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Financial Sector Bailout: Second Try   March 22nd, 2009
Indication that new financial sector bailout plan will be announced Monday       


More observations...

There are reports that the Obama administration will unveil their latest $1 trillion attempt to fix the financial sector on Monday.

The Obama administration's latest attempt to tackle the banking crisis and get loans flowing to families and businesses will create a new government entity, the Public-Private Investment Program, to help purchase as much as $1 trillion in toxic assets on banks' books...

The plan on toxic assets will use the resources of the $700 billion bank bailout fund, the Federal Reserve and the Federal Deposit Insurance Corp.

The initiative will seek to entice private investors, including big hedge funds, to participate by offering billions of dollars in low-interest loans to finance the purchases. The government will share the risks if the assets fall further in price.

The last paragraph sounds like the same thing that Geithner proposed back in February and which caused the markets to dive. The first paragraph sounds like the original plan that was proposed by Paulson to buy bad assets, but now it's going to cost a trillion rather than the $700 billion (of which $535 billion has already been squandered ).

The interesting part is the second paragraph. The resources of the original bank bailout are down to about $165 billion . The FDIC doesn't have any money and neither does the federal government.

That means that the money for this is going to come from the Federal Reserve. Doing the math above, it seems like the Federal Reserve is going to have to pony up $1000 - $165 = $835 billion for this plan.

When it was announced that the Federal Reserve would start printing money, they stated they'd be buying $750 billion in mortgage backed securities from Freddie Mac and Fannie Mae. So it may be a safe assumption that the money they were going to create to buy those $750 billion in mortgage backed securities was to fund the plan that the administration will announce Monday.

However, if the Federal Reserve is planning on creating another $835 billion for Obama's plan in addition to the $750 billion it announced on Wednesday, that would amount to the announcement of printing nearly $2 trillion in the last week. Let's hope that's not the case.

As for the plan itself, we'll have to see the details tomorrow. But it still seems to me that the Republican alternative to the bailout would be better, easier, and less costly.

Update 3/23/09: The plan has been officially unveiled .

To achieve the goal of freeing up more lending, the program would entice private investors with low-cost loans provided by the Federal Deposit Insurance Corporation and the Federal Reserve. The government would also shoulder the vast bulk of the risk.

In one example used in the fact sheet, the purchase of a batch of bad mortgage loans would see the private investor put up 6 percent of the cost with the rest provided by the government, with the FDIC covering 84 percent of the cost with a loan and the remaining 6 percent coming from funds from the $700 billion bailout program.

The story above is a little vague, bordering on inaccurate. The example they're talking about is on page 4 of the fact sheet .

What it amounts to is a bank has $100 of troubled assets it wants to get rid of. It goes to the FDIC and, if approved, the FDIC auctions off the bad asset to the highest bidder in the private sector. Perhaps someone offers $84. So the bank that is getting rid of the troubled asset gets $84 in cash instead of the $100 it thought it was worth, but at least now they have cold, hard cash and they know what it's worth. The toxic asset is off its books.

Of the $84, the FDIC (which has no money) would extend a guarantee for up to $72 (85%). The remaining $12 would be funded to the tune of $6 (7.5%) by the private investor and $6 (7.5%) by the U.S. Treasury (which has no money). It seems what this really means is that the private investor has to come up with $78 (the $72 plus the $6)--because the FDIC isn't funding the $72, it's guaranteeing it. Which means a private investor would invest $78, but if things go bad then there's no way the asset will ever be worth less than $72 because the FDIC is guaranteeing that level of value. So that means the most an investor can lose is the 7.5% he put up. But, apparently, any profit beyond the $84 is for the investor to keep.

Additionally, the FDIC will be paid a fee by the investor for the guarantee of the loan.

I could be wrong, but I think this actually amounts to the Republican alternative that was proposed long ago (back in September 2008). The only difference seems to be that this plan apparently requires the banks to sell their troubled assets where it seems the exact same plan could be used to guarantee the assets for the banks without them having to sell them... and accomplish the same thing without having to find investors. As long as the troubled assets are "guaranteed" at a certain level, banks holding those assets will then know the minimum amount they can value those assets at and that's really all they need to know for them to not be "troubled." I guess the possible advantage is that by selling the troubled assets for $84 it allows the bank to have that $84 in cash to loan to someone else. It's an open question whether that's really a good or bad thing. It also remains to be seen whether we actually have enough money at this point to fund it... having squandered most of the original $700 billion bailout and another $787 billion on the Obama spending bill.

In any case, I'll analyze this further later... but for now it looks like the administration has adopted the Republican proposal. 2 hours into the trading day the market has rallied 270 points (3.7%).

Update 3/23/09 Later in the Day: I struck out a bunch of text I wrote above. Based on my reading of the Treasury plan, the FDIC would guarantee the $72 portion... but I'm reading in multiple places that the FDIC would actually loan the $72:

Under a typical transaction, for every $100 in soured mortgages being purchased from banks, the private sector would put up $7 and that would be matched by $7 from the government. The remaining $86 would be covered by a government loan provided in many cases by the Federal Deposit Insurance Corp.

For example, for a group of deteriorating mortgages purchased by a PPIP for $840,000, private investors would put up $60,000, the Treasury would invest $60,000, and the FDIC would provide a loan of $720,000.

The FDIC doesn't have any money! How is it going to loan money it doesn't have? Unless, as mentioned above, these are the $750 billion in securities that the Federal Reserve announced it would purchase with newly printed money. Or perhaps the Federal Reserve is going to print even more money? I don't know, but the FDIC definitely doesn't have money to loan.

If these reports are correct then it basically means that the U.S. Government (that doesn't have money) and/or the Federal Reserve (which only has money when it prints it) are going to basically be paying for 93% of the toxic assets with private investors paying the other 7%... but the government and the private investors share equally in any profit???

Potentially even more amazing:

Officials said they expect participation by a broad array of investors ranging from pension funds and insurance companies to hedge funds. To achieve that goal, the program would be set up to entice private investors with low-cost loans provided by the Federal Deposit Insurance Corporation and the Federal Reserve. The government itself would shoulder the bulk of the risk.

It seems to me that the above paragraph is suggesting that private investors could obtain low-cost loans from the FDIC and/or Federal Reserve to fund their 7% investment? In other words, 93% of the funding would be by the government... and the other 7% could be borrowed from the government??? And the private investors share equally in any profit???

This seems like the original Paulson plan from September to simply have the government buy up toxic assets, but now any potential gain is shared with private investors who have contributed only 7%.

Apparently other Republicans are equally baffled:

Whereas Geithner suggested there was no alternative to the plan, Republicans said otherwise. House GOP Whip Eric Cantor said he hoped the administration would consider instead an earlier GOP proposal to set up a government-sponsored insurance program for mortgage-related securities.

Cantor, R-Va., called Obama's plan a 'shell game' that hid the true cost.

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