Billions From Heaven

By Cernig

I keep reading about the Republican Eric Cantor's plan being better than Paulson's Folly because it says banks, financial firms and other investors holding toxic mortgage securities would pay premiums to the Treasury to finance the insurance coverage. The idea is that institutions holding higher-risk securities would require higher premiums and the whole thing would involve the investment houses forking over instead of the taxpayer.

Huh? This whole plan relies on most people thinking "insurance" just flies out of the heavenly spheres fully formed. But no-one knows how much these toxic debts are worth and it seems to me that if no-one can set a fair price for buying them outright, then no-one can set a fair premium for them. The premium, following good insurance practice, given that these debts are toxic and pretty much certain to result in payouts anyway, should be as near to the costs of just taking them on outright as makes no difference anyways. Think of it as just a form of gambling - you don't give decent odds to someone betting on a sure thing. That is, the costs of insurance will be exactly the same to the taxpayer in 2008 dollars as the costs of the Paulson bailout - just kicked down the road instead of right now. By which time, inflation and prospects for the dollar being what they are, they'll cost one heck of a lot more. And along the way, the Republican plan will have drained some more liquidity out of the financial system and helped finance house along the road to insolvency as the banks will have to reserve money to pay premiums that they could be lending to Main Street USA at financially sound terms instead.

It looks like a political shell game to me, relying on common ignorance about insurance to push a plan that is actually functionally worse than the one it would replace while having almost exactly the same long-term costs to the taxpayer, only disguised in the short term for the GOP's political advantage. "Look how much we saved taxpayers!" It would also, according to Cantor's bullet points, remove " regulatory and tax barriers" - the same old Republican mutton dressed as lamb.

The other Republican plan floating around - that there be less regulation, more tax cuts and a suspension of capital gains tax for assets that are worth less than paid for them - is just dumb economically. It's a transparent attempt to hand ownership of the crisis to Dem's by throwing a spanner in the works then proclaiming loudly that they preside over a "do nothing Congress" and have wrecked the economy by their failure to act.

Warren Buffett today was quite clear where that kind of petty political obstructionism is going:

“We are looking over a precipice in terms of the economic condition of the country for the next few years,” Buffett said during an interview on the Fox Business Channel. “If Congress doesn't help us on this, heaven help us.”

So we have two alternatives, because Paulson's Folly really is dead. The Republican alternative calls for kicking the can down the road, increasing taxpayer costs thereby, making no meaningful plans to regulate financial services and even so leaving the taxpayer empty-handed at the end of it all. The Dem plan puts the costs up front but in tranches so that no-one is running away with taxpayers money without accounting for it and leaves the taxpayer owning a sizable chunk of admittedly partially damaged banks. Where's the debate?

Update: Something else just occured to me. It has been suggested that some of the toxic debt might not be so toxic after all and that some might even show a profit if the Treasury could "hold to maturity". If so, Cantor's plan really is outrageous because it would let the finance houses keep the profit for such while the taxpayer indemnifies them for the bad. And if the banks can in any way identify which portion of their toxic debt might be good at "hold to maturity" prices, they don't even need to pay the insurance premiums on that portion. The manager of the country’s largest bond mutual fund thinks his team can indeed seperate the truly bad from the potentially good, and has offered to do the job for the Treasury for free.

Comments

[anderson]

Cernig,

While I agree that the "insurance" scheme has as much potential to be as expensive as an up front bailout, I think the merit is that insurance is an ex post facto payout, which means the Treasury doesn't have to figure out which loans may or may not go bad in order to take them off sheet. Everyone agrees such a task is impossible, so rather than up front guessing, an insurance plan pays out only on actual failure and not before.

As you say, figuring the premiums would be difficult, but statistically based. Not nearly as hard as predicting all failures a priori.

[anderson]

Surely the worst of all these piddling schemes is that there seems to be no thought as to how to stop the source from bleeding out, namely the houses falling into foreclosure. With another 2 million foreclosures expected next year and the year after that, all this money is going to do is clear up the balance sheets of Wall Street. Unless proposals come with some mechanism to stanch the foreclosure bleed out, $700 billion will change nothing except short term leverage ratios. Regulation must also enter the picture, including restrictions on leverage.

If you didn't see it, check out Market Ticker's Karl Denninger's solution:

1) ALL level 3 assets must be disclosed IN FULL.
2) ALL OTC derivatives must be moved to a public exchange in 90 days.
3) Leverage ratio limit 12:1.

http://www.youtube.com/watch?v=9KYtD-Ff_eM

[Steve Hynd]

Hi anderson,

Agreed on your second. I don't think you're getting my point with your first comment though. What statistics can they possibly base premiums on? There are none. Setting a premium isn't taking a wild guess, and if you're taking wild guesses its better to get the pain over with and fixed on the balance sheet.

Regards, C

[anderson]

Well, statistics like home foreclosure estimates, which right now stand at about 10% of all mortgages. For Fannie and Freddie, that means about $500 billion in expected losses. But you may be right, because no one really knows how many MBS vehicles the failing mortgages occupy. The other problem with the insurance scheme is that everyone is making the argument that, with credit markets frozen, the lump sum is needed to provide immediate liquidity, and that doesn't happen with an insurance plan.