If the idea of the government setting up a "bad bank" to manage troubled assets sounds ugly, there's an idea that could be even uglier: insuring these toxic securities.
It's already being done. In recent weeks, the Treasury Department has set up guarantee plans for giant pools of bad assets from Citigroup (nyse: C - news - people ) and Bank of America (nyse: BAC - news - people ). The guarantees seek to limit the losses the banks will face on these bad assets and reduce some of the uncertainty about the banks' balance sheets.
Providing guarantees on pools of banks' toxic assets might be termed the "lazy man's bailout." On the face of it, the government does not run into the complex valuation problem, a symptom of trying to purchase the assets. Instead, the Treasury can just circle some assets, name a price, slap on a premium and--voila!--Uncle Sam to the rescue.
Of course, in reality insurance is much more difficult (just ask AIG (nyse: AIG - news - people )). Private insurance companies complete complex analyses involving deep actuarial evaluation to create guarantees. And that's just for everyday life insurance policies.
So imagine how difficult it would be to price an insurance policy for a $306 billion pool of abstruse assets, as in Citi's case. In order to do so, an insurer would have to look at all of the assets in the pool and have some sort of performance assumption, estimating loss scenarios it could face.
Determining the future performance of these assets is a problem the Treasury is trying to avoid in the first place. After all, if the government can predict the future, it might as well purchase the securities and establish that bad bank everybody is talking about.
Treasury officials did not respond to a request for comment.
Up to now, the guarantees the Treasury has put in place have been rather benign. They limit the government's losses on Citi's $306 billion pool to $15 billion and Bank of America's pool of $118 billion to $10 billion. That means any losses in excess of this amount will be the banks' responsibility.
Given the fees the government is charging, this comes out to a net protection of between 3% of Citi's pool of toxic assets and 5% of Bank of America's. Peanuts. If these assets are so bad, any losses would likely exceed 5%.
If the Treasury wants guarantees to accomplish anything significant, it will have to structure them to expose the government to the vast majority of losses, critics argue.
Without loss limits on the guarantees for Citi and Bank of America, the exposure to taxpayers would be staggering: nearly $350 billion.
The upside? Sure, the government will charge the banks a fee. But for that fee to be enough to protect taxpayers, it would need to be so high that banks couldn't afford it. Meanwhile, the government would eat nearly all of the losses for up to 10 years.
This begs the question: With a guarantee program, is the Treasury doing what's in the best interest of taxpayers or what's easiest?
"What's being really stated is that the Federal Reserve and Treasury have no trust in the FDIC to resolve failed institutions," says Joshua Rosner, an analyst at investment research firm Graham Fisher & Co.
"Instead, they are asserting that no large intuitions should be resolved," he adds. In particular, Rosner sees guarantees as a way to specifically protect the large New York banks--a cause very close to new Treasury Secretary Timothy Geithner's heart as former head of the New York Federal Reserve.
Allowing the Federal Deposit Insurance Corporation to run a bad bank could very well involve the failure of some large banks that could not sustain the write-downs associated with these asset sales.
That might be a tough pill to swallow, but it's better than the alternative. Until banks recognize all their losses, the credit crunch will continue and the economy will remain stalled indefinitely.
For this reason, Brian Olasov, a banking expert from McKenna Long & Aldridge LLP, is also unconvinced that pursuing guarantees on the toxic assets will solve the problem. "I would be very leery of false solutions that seem like delay tactics in recognizing problems."
So are investors. The share prices of Citi and Bank of America did not suddenly soar after their guarantees were announced.
Providing responsible guarantees with taxpayers' best interest in mind is not any easier than purchasing assets for a bad bank. But, as Rosner has argued, in the bad bank scenario, at least the taxpayers gain any upside that these troubled assets might see. By insuring them, that upside will still belong to the banks holding the assets. Yet, if the assets incur losses, the government pays in either plan.
If Geithner's Treasury has the best interest of taxpayers in mind, he might seek a bailout that provides them some upside and gets the financial industry out of its funk as quickly as possible. Guarantees might be an easy fix, but they might not accomplish either of these goals.
It's already being done. In recent weeks, the Treasury Department has set up guarantee plans for giant pools of bad assets from Citigroup (nyse: C - news - people ) and Bank of America (nyse: BAC - news - people ). The guarantees seek to limit the losses the banks will face on these bad assets and reduce some of the uncertainty about the banks' balance sheets.
Providing guarantees on pools of banks' toxic assets might be termed the "lazy man's bailout." On the face of it, the government does not run into the complex valuation problem, a symptom of trying to purchase the assets. Instead, the Treasury can just circle some assets, name a price, slap on a premium and--voila!--Uncle Sam to the rescue.
Of course, in reality insurance is much more difficult (just ask AIG (nyse: AIG - news - people )). Private insurance companies complete complex analyses involving deep actuarial evaluation to create guarantees. And that's just for everyday life insurance policies.
So imagine how difficult it would be to price an insurance policy for a $306 billion pool of abstruse assets, as in Citi's case. In order to do so, an insurer would have to look at all of the assets in the pool and have some sort of performance assumption, estimating loss scenarios it could face.
Determining the future performance of these assets is a problem the Treasury is trying to avoid in the first place. After all, if the government can predict the future, it might as well purchase the securities and establish that bad bank everybody is talking about.
Treasury officials did not respond to a request for comment.
Up to now, the guarantees the Treasury has put in place have been rather benign. They limit the government's losses on Citi's $306 billion pool to $15 billion and Bank of America's pool of $118 billion to $10 billion. That means any losses in excess of this amount will be the banks' responsibility.
Given the fees the government is charging, this comes out to a net protection of between 3% of Citi's pool of toxic assets and 5% of Bank of America's. Peanuts. If these assets are so bad, any losses would likely exceed 5%.
If the Treasury wants guarantees to accomplish anything significant, it will have to structure them to expose the government to the vast majority of losses, critics argue.
Without loss limits on the guarantees for Citi and Bank of America, the exposure to taxpayers would be staggering: nearly $350 billion.
The upside? Sure, the government will charge the banks a fee. But for that fee to be enough to protect taxpayers, it would need to be so high that banks couldn't afford it. Meanwhile, the government would eat nearly all of the losses for up to 10 years.
This begs the question: With a guarantee program, is the Treasury doing what's in the best interest of taxpayers or what's easiest?
"What's being really stated is that the Federal Reserve and Treasury have no trust in the FDIC to resolve failed institutions," says Joshua Rosner, an analyst at investment research firm Graham Fisher & Co.
"Instead, they are asserting that no large intuitions should be resolved," he adds. In particular, Rosner sees guarantees as a way to specifically protect the large New York banks--a cause very close to new Treasury Secretary Timothy Geithner's heart as former head of the New York Federal Reserve.
Allowing the Federal Deposit Insurance Corporation to run a bad bank could very well involve the failure of some large banks that could not sustain the write-downs associated with these asset sales.
That might be a tough pill to swallow, but it's better than the alternative. Until banks recognize all their losses, the credit crunch will continue and the economy will remain stalled indefinitely.
For this reason, Brian Olasov, a banking expert from McKenna Long & Aldridge LLP, is also unconvinced that pursuing guarantees on the toxic assets will solve the problem. "I would be very leery of false solutions that seem like delay tactics in recognizing problems."
So are investors. The share prices of Citi and Bank of America did not suddenly soar after their guarantees were announced.
Providing responsible guarantees with taxpayers' best interest in mind is not any easier than purchasing assets for a bad bank. But, as Rosner has argued, in the bad bank scenario, at least the taxpayers gain any upside that these troubled assets might see. By insuring them, that upside will still belong to the banks holding the assets. Yet, if the assets incur losses, the government pays in either plan.
If Geithner's Treasury has the best interest of taxpayers in mind, he might seek a bailout that provides them some upside and gets the financial industry out of its funk as quickly as possible. Guarantees might be an easy fix, but they might not accomplish either of these goals.
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