TARP II: Find a Way Into the Detention Block!

Details are emerging about the new financial rescue package. Some of the items the Wall Street Journal has reported sound far more market-friendly than what I had feared.

The centerpiece is the bad bank. While not exactly what I talked about last week, this bad bank will be funded with private sector money. Its daring, but if it can work, then I think it will achieve some of the goals I laid out in that post. A privately funded bad bank should involve less government intervention than would otherwise be.

Another key element will be a FDIC-insured covered bond program. I talked about creating a government-backed covered bond program backed by some limited government guarantee. Now it looks like it will be a reality. Basically banks will be able to issue FDIC-insured debt with maturities as long as 10-years as long as that debt is backed by loans. I’d expect this to be restricted to new loans, because the idea is to get credit flowing again.

Remember that covered bonds differ from securitizations in that the debt is an obligation of the issuing bank no matter what. So even if the loans which “cover” the bond go into default, the bank still has to pay. With a securitization, the bank sells all its risk to investors in the securitization. From a moral hazard perspective, the beauty of the covered bond program is that the risk stays with the bank who originated the loans. The FDIC (i.e. tax payers) are only on the hook in the event that the bank goes under. And we’re already on the hook for that!

From a “fix” the economy perspective, the covered bond program gives banks a guaranteed profit as long as it can underwrite good loans. The bank’s cost of funds for 10-year FDIC insured covered bonds would be about 4.5% (my own estimate, maybe lower). How easy is it to make loans well north of 4.5%? By implementing this program, the government is telling banks not to worry about their funding sources, just worry about lending the money to worthy borrowers.

The last piece of this bailout that I think will really matter is the TALF. Similar to the covered bond program, the TALF will guarantee profits to banks and other financial institutions as long as they can make good loans. Combined with the covered bond program, this should eliminate the hoarding of cash at banks.

The real trick is how the government is going to incent private investors into the bad bank. I think that if the government guaranteed some percentage of the initial purchase value, private investors would come in. I’m not sure how high this number has to be, but there is a number.

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