Toxic assets will be sold with a AAA guarantee from the US government under one of the options put forward by the Federal Deposit Insurance Company.
The FDIC has more than $36bn in toxic assets on its books, ready to sell. And apparently the corporation is seeking a decent return. Scared?
There appear to be two main differences between this plan and the one that nearly brought down capitalism: first, it’s the US government issuing the guarantee and not some special legal entity that can conveniently go bankrupt. Phew. Oh no, hang on. The second difference is that we know most of these assets are toxic, or worth less than initially thought. At least the first time round, they were bought in good faith.
There is some very poor maths going on here. Let’s say a loan of 80k was thought to be AA (first time round) and therefore its expected value was, say, 77k. Then the crisis happened, the loan was riskier than thought and the expected payout dropped to 60k. The bank owning the loan can’t offload it to the market and it is bought by a government entity for an unknown sum.
Now that entity plans to resell the 60k loan and make a profit. That depends on two things: (1) the price paid for the loan; (2) the selling price.
So far so good. Several useful things happen in this scenario: (1) We test market appetite for mortgage-backed securities; (2) we finally manage to work out the cost of the crisis; (3) we finally have a price for the loan, which, at 57k, now more accurately prices in the risk of default.
But issue that AAA guarantee and all the good things stop. Suddenly, the loan is worth 80k – with the US taxpayer on the line for the 20k shortfall. We still don’t know how much the loan is really worth. We have created a two-tier system for MBS, and confusion reigns.
Allow me an analogy. Your neighbour Bob buys a second-hand car for $10,000. He’s told it’s in perfect working order; it is not. The car breaks down all the time and Bob sells the car for $7,000 to a dealer. Now the dealer sees you coming and tries to sell you the car for $11,000. He tells you this is a terrible vehicle, but he doesn’t know how much it’s really worth. So he’ll sell it to you for $11,000 but refund you the difference if you can only sell it later for $6,500.
What a crazy idea, you think. You know the car is ropey and breaks down weekly. Plus, if all the dealers are acting like this, you’ll never be able to work out what it’s really worth and get your refund.
By issuing risk-free mortgage-backed securities, FDIC turns a nice profit in the short-term and accrues enormous risk in the medium- to long-term. But does it help banks to re-enter the MBS market? Nope.
Market confidence – in the risk-free products – will be sky-high. But market confidence in the regular MBS market? Rock bottom. Banks could have more liquidity troubles than they do now.
Is it me or is this plan crazy?
