Saturday, February 7, 2009

The next bank bailout

It's Saturday. Geithner won't give his speech until Monday, and who knows how much he'll be willing to lay on the table even then? I figure it is incumbent upon me to speculate a bit, so that, as events develop, my forecasting ability may be evaluated. (By the way, I never go back to edit earlier postings -- except for obvious typos.)

And, so, it looks like what will be announced Monday could be a fairly clever compromise. Instead of "sin eating" Wall Street's toxic assets, government will invite private investors to buy them -- but with reduced risk because of government insurance. In essence, the Treasury would be issuing credit default swaps.

If done right, it could work. The only way to get a fix on what all those "troubled assets" are worth is to get people buying and selling them again -- but will it be done right? That remains to be seen.

To my mind, doing it right involves a few basic rules. First, no asset should be insured for more than half of what the investor pays for it. Insuring assets for full "face value" is the same as buying them outright, except without the opportunity to sell them if their value increases.

Second, pre-existing credit default swaps should not be re-insured. Since the lion's share of those were sold to buyers who did not even own the securities they supposedly insured, covering them is tantamount to insuring gambling losses.

Third, government should charge a fee for the insurance it issues. Investors were willing to pay for credit default swaps in the past, and they still should be willing to do so -- especially since the insurance is being issued by government, an institution which will not default.

Fourth, participating banks should be required to write down the alleged value of all derivatives that do not find buyers in a reasonable period of time. Only in that way can we discover which banks are essentially healthy and which are among the walking dead.

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