Monday, February 09, 2009

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.


Guy said...

Is my understanding correct that the benefit of a covered bond to the issuer is increased liquidity only?

There is no transfer of credit risk, or interest rate risk to the investor?

PNL4LYFE said...

Depending on how the bank was funding the loans while it held them on balance sheet, there probably will be a change in interest rate risk. But under this plan, the main benefit is that it will qualify for insurance which will make the funding much cheaper.

Accrued Interest said...


A big problem right now is that banks are hoarding cash for fear that they could experience another run on deposits. You don't want to lend money out if you don't know where the funding is coming from.

A vibrant covered bond program would solve that problem.

Technically speaking, there is no "transfer" of either credit or interest rate risk. Think of it as regular bank debt except that a certain pool of assets has been pledged in addition to the bank's own credit worthiness.

Unknown said...

Usually the way these things work is to have a "cover pool" that serves as collateral for the entire covered bond issue program of the institution. Each issue, at least in Europe, doesn't have its own cover pool. If pool loans do become non-performing the bank must substitute performing loans. If the bank itself fails (imagine that) the covered bonds have first claim on the pool. One issue here is that holders of the longer issues in the pool could become structurally subordinated if there is a bankruptcy and the collateral cannot cover all maturities.

Advant Guard said...

Pre-crisis the FDIC only insured deposits (just ask WaMu bond holders.) It is only since Hank Paulson trashed the credit markets with his Hamlet impersonation that the FDIC has guaranteed selected bank debt (though the rules seem to become more selective all the time.) Perhaps by the end of the year, they will also guarantee bank equity (once Congress expands their borrowing authority from the Treasury to $100 billion.)

Keith said...

Will the FDIC insurance likely make the bond purchasers not care what bank issued it? I would think that dealers would want some central place they can go to buy and sell them so that they don't have to call every bank in the country to round up all the bonds they want. Otherwise GSE debt will still be more attractive.

pwm76 said...

David Merkel at the Aleph Blog has written several times about covered bonds. I couldn't find the post to link to, but I believe he argued that the existence of covered bonds subordinates most of the other creditors, thereby raising the cost of financing.

Also, isn't there a limit to the amount of covered bonds a bank can hold? I'm thinking 5% of assets, but am not certain.

Accrued Interest said...

Covered bonds do subordinate other debt holders in the same way that any secured debt does. I don't know about the limit, but I'd imagine since there isn't much of a regulator framework for covered bonds now, that any existing limit is subject to change.

Zvi is right. There isn't a static pool pledged in a covered bond situation. Otherwise the covered bond would have to amortize along with the pledged assets. A covered bond has very little in common with a MBS. Much more in common with secured debt.

Wrii: WIth current FDIC issuance it makes some difference who the bank is. Someone like Regions trades weaker than WFC.

Michael H said...
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Michael H said...

A big problem right now is that banks are hoarding cash for fear that they could experience another run on deposits.

A bank that is well capitalized but is fearing a run pays high interest rates to attract and keep depositors. This was what we were seeing early in the banking crisis when you could readily get 5% CDs even with the Fed slashing rates.

A bank that isn't well capitalized but isn't fearing a run (because of government backstops) pays very low deposit rates. Any excess deposits dumped on the system by the Federal Reserve aren't used to make new loans but instead pile up at the Fed.

I think we've moved beyond the fear and have moved towards the zombie bank scenario. Banks are unable or unwilling to make loans because they can't value their balance sheets.