Deferred Fed Money Printing

Submitted By Michael Krause
On the new Geithner's new TARP program, let's take a discounted asset as an example. The below example is based on the assumption the FDIC backed debt is priced to short term rates (cheap .25% fed funds will do). The bidding price of these assets will fall as the cost of FDIC backed debt goes up, of course.

Let's say we have a currently performing and underwater, but yet to default alt-A or subprime loan, but already marked down by the bank (to 60c on the dollar). Currently it is yielding likely around 5-6%. Of course, there is no acceptable market for the loan to the bank.

If I am a hedge fund investor, to buy it at par (100c), I only need to put down 8.3 cents on the dollar. The TARP fund matches it. Private market capital provides the other 83 cents, which the FDIC provides a put to the bond investor for. We are essentially transferring risk from the bank to the FDIC.

The 16.6c investment shared by the hedge/pension fund and TARP are entitled to the 5-6% annual cash flows. Split evenly, if that loan performs for just three years, all of the investment risk assumed by the TARP/hedge fund is recovered entirely. After that, cash flows are pure riskless profit. Cashflow will determine the price, but anything with decent cashflow will likely go for par or above. That would give the owner of this new loan (and thus leveraged collateral, if there is any) incentive to keep the house producing income at any expense: renting it out, lowering interest rates, etc. After that initial payoff period, the FDIC's assumed risk on the portion of the loan they are insuring skyrockets. In the end, whatever the FDIC loses, the Fed will print to offset.

Without knowing the specifics of what level of consent the FDIC has on what they insure, or on the terms of the FDIC-backed debt that will be issued, the hairy details are impossible to determine.

But on back of the envelope, any substantially enough cashflowing loan that is trading far below par should mean par recapitalization for banks. In the end, the level of FDIC loss is determined by where the real estate markets are when the assets being insured generally fail. That will determine the amount of Fed money printed going forward. This seems like a perfect plan to make the FDIC (effectively the Fed) the bad bank.

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