A New Taxpayer Rip-Off: Mortgage Backed Securities From the FDIC

Includes: KBE, KRE, XLF
by: John Lounsbury

You know about all the assets received by the FDIC when a bank goes into receivership? That's the stuff that the take-over bank won't accept as assets of value. Well, as of this week the FDIC has about $37 billion of such assets, according to Barry Ritholtz at The Big Picture.

Ritholtz says that the FDIC is strapped for cash and has filed for a pilot program to package these as MBS (mortgage backed securities) and sell them as government guaranteed securities. He says the securities will sell for somewhere between 10 cents and 50 cents on the dollar, best guess. The result, if all $37 billion are so disposed, is that the FDIC will gain between $3.7 billion and about $18 billion in additional cash in reserve for future back failures.

Isn't this a good thing? Wait just a minute. If these MBS are worth what is obtained for them, then the buyers will make a fair return on their investment. What's a fair return? How about 5% a year for seven to ten years? For a seven year term, every $10 billion of issue will return that principal plus more than $4 billion gain. After ten years the gain would be more than $6 billion.

If the securities are sold for less than they are worth, then there will be a greater return of capital that the discounted price assumed. There could be additional return beyond the assumed return from interest and principal payments. This could add another bundle to the investors' returns, perhaps an additional 5%, 10% or more.

But what if the MBS issued have higher defaults than assumed at the time the FDIC issues the securities? Not to worry investor, the U.S. government guarantees you will receive every penny of principal back at maturity (or complete default, if sooner).

So, here we go again. The government will give up all potential gains from these assets when the FDIC issues the new MBS, but will be guaranteed to assume all losses if they occur. Genius!

Sources for the Ritholtz post:

Disclosure: No stocks mentioned.