Sometime next week Barack Obama’s administration is going to reveal its new financial rescue package. Although FDIC boss lady Sheila Bair favours creating a bad bank to buy assets, and that may well be part of the final plan, it will not be the preliminary focus.
Instead, it seems very likely that at the heart of the Obama Bailout will be some form of insurance for troubled assets on the balance sheets of banks. The idea would be for the government to guarantee that it will make up for any shortfall in an asset’s value beyond a certain level. If defaults tick up on mortgages and recovery rates stay low, the government would simply pay banks for the losses on the securities backed by those mortgage.
So why is the Obama administration leaning to insuring the assets instead of buying them directly?
We’d guess that the program to purchase assets turned out to be horrifyingly expensive. Banks are unwilling to shed the assets at steep discounts. Many bankers still believe that a lot of their troubled portfolios will be worth more once the “market dislocation” clears up. That assumption that these debt linked securities will be worth far more than current market pricing indicates we’re calling the Dislocation Ideology.
But even if they were willing to give up on this Dislocation Ideology, they wouldn’t sell their bad assets to the government at market prices because this would render them insolvent. When the government got around to figuring out what it would cost to overpay enough for the troubled assets that banks would come clean, the number was almost certainly beyond anything they had contemplated.
How big could that bill be? Senator Charles Schumer has said that the bad bank could cost $3 trillion to $4 trillion. We’ve heard estimates even higher. One banker we spoke to said the bad bank would have to be prepared to spend as much as $8 trillion.
Insurance provides a much more politically palatable way of bailing out the banks. Politicians won’t have to spend a dime on day one. They’ll claim that much of the insurance will prove unnecessary because the asset values will recover. We’re sure someone will say that taxpayers could even make money on the insurance, if the premiums charged to banks wound up being higher than the pay outs on the insurance. The budget makers will come up with a rose-tinted estimate of eventually payouts, and that estimate will be based on the idea that the troubled assets will recover their value. The Dislocation Ideology will become the official policy of the United States.
Of course, if the Dislocation Ideology is wrong, the final costs of the insurance could be as high as the bad bank’s price tag. But those costs won’t be visible for years, allowing policy makers to escape responsibility for them. Insurance will be sold as a way