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Where does all the TARP money show up? TARP, of course, stands for the Troubled Asset Relief Program that became law on October 3, 2008, a program aimed at providing support for the banking system. The program was initially intended to provide liquidity-help for the troubled assets that were on the balance sheets of banks but it soon morphed into a program to support troubled banks in their capital needs as funds were made available to purchase senior preferred stock and warrants from commercial banks and other troubled financial institutions.

The first $350 billion of funds was authorized to be released on October 3, 2008 and Congress approved the release of the next $350 billion on January 15, 2009. Part of the concern with the program was that the government deficit would have to increase by $700 billion in order to create the funds. Concerns arose about how the Treasury Department would finance these payments?

One quick answer was “let the Federal Reserve monetize the debt?”

What if the Federal Reserve has already monetized the debt related to TARP? If this is the case, then two questions that have been puzzling me have answers to them. The first question relates to the increase in excess reserves in the banking system. The second question relates to the concern about how the Federal Reserve will reverse out all of the reserves that it pumped into the banking system last fall. Let’s look at both in turn.

Federal Reserve Bank Credit has increased by $1.2 trillion since just before the financial meltdown in September 2008. What has increased the most in the banking system? Excess reserves in the commercial banking system have risen by about $800 billion. Excess reserves in the WHOLE banking system had run about $2 billion before September 2008. Something unprecedented obviously took place!

In terms of policy making the creation of TARP and the response of the Federal Reserve are closely tied together. (See my post of November 16, 2008, “The Bailout Plan: Did Bernanke Panic?: http://seekingalpha.com/article/106186-the-bailout-plan-did-bernanke-panic.) As mentioned above, the first round of TARP was released in October. But, the Federal Reserve could not wait. It began pumping reserves into the banking system in the latter part of September increasing Reserve Bank Credit outstanding from about $890 billion on September 10, 2008 to $1.5 trillion on October 8, $1.9 trillion on October 29, and $2.2 trillion on November 19.

In all this action, what happened to reserve balances at the Federal Reserve? They went from around $8 billion on September 10, to $175 billion, to $420 billion, to $624 billion, respectively, on the same dates as above. Excess reserves in the banking system averaged $2 billion in August, $60 billion in September, $268 billion in October, $559 billion in November, and $767 billion in December.

Excess reserves in the banking system averaged $844 billion in May and are averaging around $800 in June. Clearly a lot of money!

The question is “Why are the banks sitting on such large amounts of basically idle cash?”

My response is that they are sitting on this cash because it is connected with the receipt of TARP monies and the banks are hoping, as some of the larger and stronger institutions have done, to repay the funds as soon as possible.

Let’s look a little closer at the data. I am using information from the H.8 release put out by the Federal Reserve System on assets and liabilities of all commercial banks in the United States. Year-over-year, through May 2009, total assets in the banking system increased by 9.7% or about $1.1 trillion. Cash assets in the banking system increased a whopping $731 billion or at a year-over-year rate of 236%. This is comparable to the year-over-year increase in excess reserves observed on the H.3 release of the Federal Reserve providing data on bank reserves.

Given my post of last June 15, 2009, “What Aren’t Banks Telling Us?”, (http://seekingalpha.com/article/143276-what-aren-t-banks-telling-us) I was interested in looking a little deeper into this information to see how these excess reserves were distributed within the banking system. Roughly the division is this. The increase in cash assets at large commercial banks was $371billion, at small banks the increase was $143 billion, and at Foreign-related Institutions in the United States, $217 billion. The increase at the larger institutions, the large banks and the foreign-related institutions, was $588 billion and this represented the immediate problem to the policy makers. The problems of the smaller banks could be dealt with later.

The reason I am interested in looking into this distribution is the claim made in the above-mentioned post that commercial banks had not been fully open with the public on the problems they were still facing. In that post I mentioned three areas of concern: the bad assets now on the books of the banks; the anticipated increase in the bad assets in the upcoming months; and finally, the needs of the banks to be able to fund themselves in the future in the face of liabilities that were maturing and would not be rolled over. The build up in cash assets, it was argued, was a precaution the banks were taking to handle the uncertainty they faced as either asset values fell or a run off of liabilities forced the banks to dispose of assets.

Here is where the TARP money comes into play. If TARP money went into preferred stock and warrants, then these monies could be used to provide capital to the banks as the banks needed to write off bad loans and securities. The stock could even be converted into capital if the funds were needed to keep the banks solvent. Otherwise the banks could use the TARP funds to pay off maturing debt that could not be rolled over in the financial markets. (See Gretchen Morgenson, “Debts Coming Due At The Wrong Time,”) Thus, monetizing the TARP debt makes a lot of sense in that it helps to protect the banking system from either bad assets that have to be written off or from financing problems resulting from the inability of the banks to roll over maturing liabilities.

What does this have to do with the Federal Reserve being able to unwind all the Reserve Bank Credit that it has pumped into the system? Well, when the banking system gets its act in order and charges off the loans and securities that it needs to and when its refinancing needs are satisfied, banks can then repay the TARP money to the Treasury as have the large financial institutions that have already repaid the TARP funds that they received. And, as the TARP monies are repaid, Reserve Bank Credit will decline so as to reduce the concern over the Fed monetizing the federal deficit.

Nice trick! The policy makers have provided a net under the banking system if the situation gets too bad in order to protect it against things falling apart and paralyzing the financial system. And, they have built into the system the means of reducing reserves as the financial system strengthens so as to avoid concerns over possible future inflation.

One final question: have the actions of the Federal Reserve had any impact on bank lending? The answer is “Not Really!” Year-over-year, loans and leases at all commercial banks increased by a tepid $182 billion or at a 2.6% annual rate. And, where were these increases located? Generally in home equity loans, consumer loans, and other residential loans (primarily mortgages) satisfying consumers needs for ready cash through consumer credit or the refinancing of homes. And, these loans were pretty evenly spread throughout the banking system.

Bottom line, however, is that the banks aren’t lending! Especially in the areas of commercial and industrial loans and commercial mortgages. Does that tell you something?

Continue to Part II >>

Source: Is Treasury's TARP Debt Already Monetized?