The New Toxic Asset Bailout Plan

First, we have a new name for toxic assets: they are now “Legacy Securities”. More importantly, they are residential mortgages and other asset-backed securities. But here is the most significant point about Geithner’s plan: it will only buy securities with AAA ratings at origin. AAA ratings are the highest possible rating: from the Standard and Poor’s definition: “The obligator’s capacity to meet its financial commitment on the obligation is extremely strong.” In short, the toxic asset bailout is for the highest rated debt there was, “at origin”. In these packages, there will be very few loans that are not paying on time, and virtually none in default.

The fact that the Federal government has to “make a market” for these loans attests to just how frozen up the credit markets have become. How will the purchase of these high quality assets help banks? After all, they are probably yielding around 6%. One might argue: at these rates, let the banks hold them to maturity.

There are at least a couple of answers:

  • Federal and state bank regulators require all banks to maintain certain risk-based capital ratios. These are to insure that banks have enough cash and highly liquid securities on hand to cover cash needs for deposit fluctuations. Without going into details on this, these ratios fall (making the bank regulators uneasy) whenever a banks assets become less liquid (like when the market for an asset vanishes: like with asset-backed securities). If banks can replace asset-back securities with cash, their capital ratios improve.
  • If you are an insurance company or a bank that guaranteed the value of an asset-backed security package to another institution, and somebody buys that package, you are off the hook for all but the difference between what you guaranteed the package for and what the new buyer pays for it. I suspect that some institutions have such guarantees that are not reflected in their balance sheets.

Okay. So if these are the problems, are there other, cheaper ways to resolve these problems that Geithner’s program? First, a bare-bones summary of the toxic asset proposal:

  • Take another $80 billion from TARP, add it to the $20 billion already set aside for TALF so we have $100 billion of taxpayers’ money to make equity investments in toxic assets (I keep a running tab on TARP outlays: this will “break the bank” in that the President will have to go back to Congress for approval to spend the second $350 billion of TARP money);
  • Get the private sector to come up with the same amount ($100 billion);
  • The FDIC will guarantee loans to generate 6 to 1 debt – equity ratio or a total of 6 X $200 billion = $1.2 trillion. An FDIC loan guarantee is presumed to make any loan a liquid asset. If a bank can replace its AAA rated toxic mortgage for with a loan guaranteed by the FDIC, its capital ratios improve, making the bank regulators happy and allowing the bank to expand its loan portfolio.

It is worth noting that in this example, I said an FDIC guarantee is presumed to make any loan a liquid asset. But the FDIC is in something of a bind. With all the bank failures, it had only $19 billion left at the end of 2008 for other bank failures. Big bank failures can be expensive: the IndyMac collapse cost $10 billion. So FDIC Chairman Sheila Bair proposed raising insurance fees on its member banks; that did not sit well with the banks, so Senator Dodd has introduced a bill to allow the FDIC to borrow as much as $500 billion from the US Treasury. Another new Treasury obligation? See my last posting on how the Treasury for a detailed explanation on how the Treasury will finance all its new obligations.

Assessment

Will this program even get off the ground? It will take some time: Congress has to approve the second $350 billion of TARP and private sector investors will have to sign up. Will tghere be a problem in attracting private sector investors? It remains to be seen: TALF, a similar program for consumer, students, and small business loans, has not generated much private sector interest. But we are talking about buying AAA rated mortgages at the bottom of the real estate cycle…. It sounds good. Can you or I apply? Sure, providing you currently have $10 billion of assets under management.

So here we are with a new program that will use another $100 billion of US taxpayers money to purchase mortgages and other asset-backed securities with a AAA rating. Is there a less cumbersome this might be done? Like, for example, having the FDIC guarantee these AAA toxic assets directly? Such an action would both make them marketable again and allow the bank supervisors to take them out of the high risk category on banks’ balance sheets. Am I missing something?

The content above was saved on the old Morss Global Finance website, just in case anyone was looking for it (with the help of archive.org):
This entry was posted in Global Economics, Global Finance. Bookmark the permalink.