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Reuters reports that the Federal Deposit Insurance Corporation (FDIC) has seized fifteen banks so far in 2010. That puts the FDIC-assisted bank failures on pace to exceed the 140 in 2009. The FDIC is increasingly open to every trick in the book to unload this inventory at the best prices that it can. Increasingly, the successful bidders to take over failed banks have been private equity firms instead of the more common method which involves purchases by well capitalized banks.

The FDIC floated a plan in the Financial Times last week to securitize its left over junk loans and real estate assets with a FDIC, and ultimately taxpayer, guarantee. They have an inventory of $36 billion in toxic assets and that inventory will only climb. My paper “Slicing the Toxic Pizza” indicates that such a plan is not the money loser for taxpayers that it seems at face value.

Since the FDIC is the owner of the loans underlying any securities and the guarantor of those securities, my research shows that any boost in the sales price is exactly offset by the liability associated with the debt guarantee issued by the FDIC. I argue in another paper that the FDIC is unlikely to participate in purchases toxic assets from solvent banks. (This is a good thing since that latter paper argues that the costs of buying toxic assets from troubled but solvent banks would be very expensive.)

Seller finance is often a way too boost sales prices. GM learned this many decades ago when it was competing with Henry Ford’s Model-T. Providing financing allowed GM to become the largest automaker in the world for many decades.

An asset guarantee may be a way of boosting sale prices, because a bondholder gets a junk note with an airtight taxpayer guarantee that makes even the most questionable debt security look like a U.S. Treasury note or more aptly a Fannie Mae or Freddie Mac security. This is a way of broadening the potential investor base. Dan Freed at the Street.com reports that, over the past year, strong banks, which buy failed banks, have seen their share prices climb like they have won the lottery. That begs the question of whether the FDIC has been leaving some money on the table. The FDIC may get more money selling the loans to investors than to other banks.

Yet, if the FDIC slaps a guarantee on some questionable real estate loans, it is taking a bullish bet on a housing recovery. The FDIC is selling a put, which is not unlike a credit default swap (CDS), and a put (CDS) seller is making a bullish bet that the put will never be exercised against him or her. Even, if, in expectation, the net gain from selling the loans with or without the guarantee is the same, the markets do not always conform to expectations. If real estate markets perform worse than expected, the FDIC and ultimately taxpayers will have to make securities investors whole. In that way, the FDIC is liable to lose much or all the proceeds from the securities sales. Let us hope that real estate markets perform better than expected.

Disclosure: I only have long positions in broad-based index funds.

Source: FDIC's Toxic Asset Securitization Plan Could Work