An Alternative Bailout Plan

Now that both sides of the U.S. House of Representatives cannot agree on Hank Paulson’s $700 billion TARP package, the need for an alternative idea is clear. One of the ideas I have heard sounds pretty interesting to me.

Essentially, rather than buying $700 billion worth of mortgage-backed securities, the plan would be to have the government issue insurance on them and guarantee the holders against realized losses. How is this any better than the current plan? From what I can tell, in at least two ways.

First, it would cost far less to insure mortgages than it would to buy them outright, so the taxpayer would save money versus the current plan. Many people believe the current prices these bonds are fetching (if trades occur at all) are not reasonably reflecting the ultimate losses from the mortgages underlying the securities. If that is true, the losses that the U.S. would insure against would be far less than the current marks on these mortgages are predicting.

Second, and perhaps more importantly, if we woke up tomorrow and these mortgages were insured by the U.S. government, there is a very good chance that demand for them would increase significantly. All of the sudden a market for these securities would not only exist (essentially one does not now), but prices would likely rise and the banks could reverse some of their mark-to-market losses and write-up the value of their assets. With more clarity on the value of these assets, even more capital raising would occur in the banking sector.

So, what do you think? Would such an idea convert some of the naysayers of the current plan?

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3 Thoughts on “An Alternative Bailout Plan

  1. Anonymous on September 30, 2008 at 11:24 AM said:

    It seems that many of the arguments you are making for this bill would apply equally to the last bill.

    The real issue is how do you come up with the insurance rates? Every loan pool is different, would need to be analyzed and at the end of the day how do you realistically put a number to it. Even if you can put a number to it, do you trust Paulson to use an insurance rate that is advantageous to the American public or to the banks bvenefit (Goldman Sachs). I mean it is so subjective you just can’t put it into the bill how to price the things, it is completely dependant on people’s integrity. Given the state of wall street, I would say the integrity of the entire industry is seriously in question.

  2. Kaberi and Vik on September 30, 2008 at 3:15 PM said:

    I respectfully submit that there are some real drawbacks to this idea.

    By having the government insure the mortgages, you are, in essence, in essence, writing a naked put on the “toxic” mortgage assets.

    So, while the initial outlay to the taxpayer will be lower, the notional exposure ($700 bil) will remain the same.

    However, the U.S. taxpayer has no upside whatsoever in this scenario (other than an upfront premium that may or may not be part of this scenario). The taxpayer will not share in any of the upside of guaranteeing these mortgages (as that upside will reside with the financial institutions).

    However, the U.S. taxpayer has all of the downside of these mortgages going to zero (and I suspect some of them will as a result of a reverse auction that could very well reflect a “winner’s curse.”) Think of this another way, if I offered to buy the clothes of you and your friends (but only at the lowest price offered by any of you), I’m guessing that I would end up with a lot of ripped and stained stuff as opposed to trendy, expensive designer gear.

    Zero upside / unlimited downside. That’s not exactly the kind of investment we want our government making (although we could argue that the W administration already went down this path in Iraq).

  3. There’s no initial outlay in the Paulson plan either. It’s basically swapping the bad mortgages for new treasury bonds. The outlay then is in paying interest to the banks on those bonds while receiving interest on the mortgages. But as Kaberi and Vik say it has more potential upside than this insurance proposal even without warrants which are mainly an instrument to deal with assymetric info between the banks and the government in reality.

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