Geithner's Plan: FDIC as the Bad Bank

To understand Geithner's new TARP program, let's take a discounted asset as an example. The example below is based on the assumption that FDIC-backed debt is priced to short term rates (cheap .25% fed funds will do). The bidding price of these assets will quickly fall as the interest rate of FDIC backed debt goes up, of course.

Let's say we have a currently performing and underwater, but yet-to-default alt-A or subprime loan. Its already been marked down by the bank (to $0.60 on the dollar). Currently it is yielding likely around 5-6%. Of course, there is no acceptable market for the loan to the bank.

If I am a hedge fund investor, to buy it at par (100c), I only need to put down 7.5 cents on the dollar. The TARP fund matches it. Private market capital provides the other 85 cents, which the FDIC provides a put to the bond investor for. We are essentially transferring risk from the bank to the FDIC.

The $0.15 investment shared by the hedge/pension fund and TARP are entitled to the 5-6% annual cash flows. Split evenly, if that loan performs for just three years, all of the investment risk assumed by the TARP/hedge fund is recovered entirely. After that, cash flows are pure risk-less profit. Cash flow will determine the price, but anything with decent cash flow will likely go for par or above. That would give the owner of this new loan (and thus leveraged collateral, if there is any) incentive to keep the house producing income at any expense: By renting it out, lowering interest rates, etc.

After that initial payoff period, the FDIC's assumed risk on the portion of the loan they are insuring skyrockets. In the end, whatever the FDIC loses, the Fed will print to offset.

Without knowing the specifics of what level of consent the FDIC has on what they insure, or on the terms of the FDIC-backed debt that will be issued, the hairy details are impossible to determine.

But on back of the envelope, any substantial (enough) cash-flowing loan that is trading far below par should mean par recapitalization for banks. In the end, the level of FDIC loss is determined by where the real estate markets are when the assets being insured generally fail. That will determine the amount of Fed money printed going forward. This seems like a perfect plan to make the FDIC (effectively the Fed) the bad bank.

Disclosure: Long stocks

Comments

[bartpr:]

i dont understand your par assumption. if only 60% of the mortgages under a security are perfroming, you are saying the treasury would
subsidize the 40% of vlue that is gone. defaulted and forclosed
properties. i think not.

Mar 24 07:26 AM

[Chezfrederick:]

Just remember... FDIC garantees and money printing come off the back of taxpayers, present and future...

Mar 24 07:31 AM

[SHARK$BUCK$:]

you are long stocks since last week or last year, I think you know the difference.

Mar 24 12:42 PM