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The newest bank bailout facility is picking up steam, courtesy of Congress. Yesterday the Senate passed legislation that would increase FDIC’s credit line on the U.S. Treasury from $30 billion to $500 billion.* Some is intended to shore up FDIC’s Deposit Insurance Fund, which at the end of December had dwindled to $19 billion, a tiny figure relative to $6.4 trillion worth of bank deposits and other debt protected by FDIC guarantees.

But most of the new credit line is intended to finance Tim Geithner’s complicated plan to rescue banks from so-called “toxic assets.”

This task is not easily accomplished. Banks won’t part with assets at realistic—i.e. low—prices. To do so would involve huge writedowns that could wipe out shareholders and force losses onto creditors. But the Obama administration (and the Bushies before them) fear(ed) this might crash the financial system. By their logic protecting bank investors is necessary to avoid systemic failure. So Treasury must effect asset purchases at artificially high prices in order to protect bank investors from losses. This is difficult since taxpayers have no interest in overpaying for bank garbage.

If not taxpayers, then who? Private investors don’t want to buy junky debt securities backed by rapidly depreciating collateral; not unless they can find super-cheap, no-strings-attached leverage to help them goose returns on their equity.

Enter FDIC. As part of Tim Geithner’s “public private investment plans,” FDIC would provide low rate, non-recourse loans to lever up private investor returns. As originally outlined, investors can put down as little as $7 to finance the purchase of $100 worth of toxic assets. Another $7 is provided by Treasury and the remaining $85 would be financed by FDIC. For investors, it’s a cheap way to take a flyer.

If toxic asset prices manage to climb, investors will have large returns relative to their sliver of equity. If asset values decline substantially, which seems more likely, they would lose just $7. They needn’t worry about the $85 in debt since FDIC has no recourse to seize any of their other assets.

Left holding the bag will be taxpayers, who, per the Senate’s bill, are providing FDIC an open line of credit at Treasury.

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*FDIC likes to make its commitments appear smaller than they really are by labeling some “temporary.” For instance, it will only own up to backing $4.8 trillion worth of deposits and bank debt. The true total, counting temporary increases in deposit insurance limits, is actually $6.5 trillion. Similarly, only $70 billion of the increase in its credit line is treated as “permanent,” while the remaining $400 billion expires at the end of 2010. But the “temporary” tag is unlikely to live up to its name in either case. Were the credit line or increased insurance limits allowed to expire, it might prompt the kind of bank panic FDIC seeks to avoid. As Milton Friedman once remarked: “nothing is so permanent as a temporary government program.”

Source: After Stress Test Results: Taxpayers Still Left Holding the Bag