The Complexity of the Bank Bailout Plan

March 25, 2009

A smart comment came from chacona in the wake of yesterday’s bailout discussion:

As for the ideas, I learned one big thing that seems to be of great importance: nobody understands the Geithner Plan.

To a first approximation, this is undoubtedly true. (It’s certainly true for me: there are large chunks of it I still don’t understand in the slightest.) For instance, during the discussion, we got into a debate about whether or not CDOs will be included among the toxic legacy assets eligible for the plan; it seems they won’t be, but it’s not crystal-clear, and if they’re not, doesn’t that leave a rather obvious weakness on banks’ balance sheets unaddressed? And that’s not even what David Reilly is talking about here:

No sooner might the Treasury Department mop up those assets than $1 trillion or more in new ones spring up to take their place.

He’s talking about off-balance-sheet vehicles: although there’s a general conception that banks have taken their SIVs back on balance sheet, Reilly says that the Big Four US banks still have a whopping $5.2 trillion in off-balance-sheet assets. That’s about 37% of GDP right there.

Reilly isn’t talking about SIVs, he’s talking about assets which the banks thought they had safely sold to external investors in the form of asset-backed securities but which they might yet be forced to take back. For instance, Citigroup has already said that it expects some $92 billion in securitized credit-card debt to come back to it.

I’m very unclear on how exactly this works, but ultimately it smells to me very similar to the notorious "liquidity put" that Citi wrote to its SIVs. We’ll sell you the assets, it basically said, but don’t worry, if they turn out to be particularly toxic, then we’ll take them back. In doing so, it retained a lot of tail risk, but didn’t need to show that risk on its balance sheet.

There are other big known weaknesses with the plan as well: even Brad DeLong, who’s making a name for himself as the most high-profile non-Administration supporter of the plan, said in the discussion that the plan "becomes very dangerous indeed" if the Big Four banks cooperate rather than compete, and also that the plan seems to be "too small to work" given the $2 trillion in expected losses on mortgage securities due to defaults.

That said, there are people — especially in Washington — who have a much stronger grasp of the details of the plan than I think any of us in the Seeking Alpha discussion had. One of them emailed me this morning, making a number of important points.

First, the FDIC will charge for its guarantee — somewhere in the region of 50bp to 100bp. What’s more, if the FDIC ends up losing money on this deal, it will make up those funds with an assessment on total bank liabilities. In other words, the banking system in general will be asked to cough up the losses, rather than the US government.

This does make it seem as though smaller, healthier banks risk being penalized to bail out the larger and more irresponsible ones — but as Brad says, someone’s got to ultimately bear the losses, and we’re all going to end up shouldering some of the burden somehow.

What’s more, the FDIC does support this plan: it wasn’t dragooned into it just to provide the extra dollars needed to get to $1 trillion. And given its guarantee fee, it might conceivably even make a profit on the whole thing. One aspect of the deal worth noting is that even if a public-private partnership and a bank come to agreement on a price for transferring the toxic assets, the FDIC can still veto the deal. You need three-way agreement for any bargain. That makes it harder for the plan to work, in the sense of money changing hands, but does make it more likely that the FDIC will avoid massive losses.

It’s also worth noting that the amount of leverage that the government allows with respect to any given asset is going to be a function of the perceived safety of that asset: maximum leverage won’t be applied willy-nilly to everything.

Finally, my correspondent says he views as a virtue of the plan the fact that regulators will push banks to mark their assets to the prices set by the auctions, even if they choose not to sell their assets at those auctions. That will accelerate failures of insolvent banks — and if an insolvent bank is going to fail, it’s better that it does so sooner rather than later.

Can this plan then be viewed as the most empirical and useful part of the stress test? Is it at heart a further step towards nationalization, or at least widespread FDIC intervention of failed banks? My feeling is that the plan is designed to maximize the prices of the toxic assets and thereby minimize the number of banks which need to be deemed insolvent. But I guess we’ll see, once the plan gets up and running.

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