The New Bernanke-Bair-Paulson Insurance Company

by Lesley Politi on December 4, 2008

The New Bernanke-Bair-Paulson Insurance Company


Uwe E. Reinhardt is an economist at Princeton.

After first trying in vain to become toxic-asset managers and, next, non-voting equity investors in shaky banks, the peripatetic trio composed of the Federal Reserve chairman, Ben S. Bernanke; the chairwoman of the Federal Deposit Insurance Corporation, Sheila C. Bair; and the Treasury secretary Henry M. Paulson Jr. decided last weekend to reinvent itself as an insurance company — hereafter the BBP Trio Insurance Inc.

Insurance of any sort is based on so-called “contingent contracts,” under which one party agrees to absorb a specified fraction of the loss that the other party to the contract might incur in specified circumstances.

Take a health insurance contract, for example. In the simplest scenario, a person buys a health insurance plan in order to partially protect himself against any medical expenses he might incur if he gets sick.

The insured person pays a regular fee, or “premium,” to the insurance company. In exchange, the insurer agrees to cover specified fractions of the expenses for necessary medical care required by the insured in case of illness. Usually, the policy contract specifies an annual “deductible” which must be met out of pocket by the patient before the insurer covers any expenses. The contract may then say the insurer will pay some percentage of incurred and approved medical expenses above the deductible, up to a specified life-time maximum. The remaining portion of the medical expenses will be paid by the patient. This portion is called co-insurance or co-pay.

The deal negotiated last weekend between the BBP Trio and Citigroup executives involves a similar contingent contract.

Here are the terms of the Citigroup insurance plan: the bank has on its balance sheet about $2 trillion in assets of which $306 billion, mainly related to real estate, are of uncertain value. In the event that those assets turn out to be worth less than $306 billion, American taxpayers will cover — that is, reimburse — Citigroup for some losses. But before taxpayers start reimbursing Citigroup for anything, up to $29 billion in losses will be absorbed by Citigroup. (This is the deductible.) After the $29 billion is reached, taxpayers will absorb 90 percent of any additional losses, and Citigroup will absorb 10 percent (this being the co-insurance).

As in a health insurance policy, there is a maximum amount of potential losses that the taxpayer will bear, but that level has not been determined. According to the “Summary of Terms” published by the United States Treasury, that maximum exposure will be “based on a valuation [of the $306 billion book value of assets] to be agreed on between institution [i.e., Citigroup] and USG [the United States government].”

The premium charged Citigroup for this asset-value insurance will be an annual cash payment of $560 million, calculated as an 8 percent dividend each year on $7 billion of non-voting preferred stock to be issued by Citigroup — $4 billion to the Treasury and $3 billion to the F.D.I.C.

That’s not all the BBP Trio is doing. After first putting on the hat of insurers, the BBP Trio then switched to the hat of equity investors once again. The trio injected another $20 billion in cash into Citigroup, on top of $25 billion injected earlier. In return for the $20 billion, the American government will receive non-voting preferred shares that pay an annual dividend of 8 percent on $20 billion, that is, $1.6 billion a year.

Both the insurance — and the equity-investment deals were further enhanced with something called “10-year warrants” These allow the United States Treasury to purchase up to 254 million shares of Citigroup common stock at $10.61 each anytime within the next 10 years. The hope is that the market price of Citigroup stock will rise above $10.61 within that time span, allowing the government to make a profit by buying bank shares and reselling them at a higher price. Although the Treasury’s “Summary of Terms” is not entirely clear on this point, a case can be made that about 66 million of these call options are part of the premium paid for the asset-value insurance contract.

The deal struck by this new BBP Trio Insurance raises two questions.

First: Is there any limit to the contingent liability that the BBP Trio (or its successors in the Obama administration) can load on the American taxpayer in this new line of business?

The original toxic-asset purchase operation rammed through the Congress turned out to be, in the Treasury inspector general’s own words, “a mess.” But still, at least there was a legislated $700 billion limit to it and some accountability, at least in principle, if not in fact. By contrast, is there any limit to the size of the insurance book of business to which the BBP Trio Insurance can expose the taxpayer, the ultimate underwriter on this insurance? I believe it is something to worry about.

Second: Is the insurance premium the BBP Trio charged Citigroup — and subsequently other banks as well — a good deal? The alternative to government insurance is private asset insurance in the form of so-called Credit Default Swaps or C.D.S.’s. The seller of a C.D.S. guarantees the value of an investment in a financial security (usually a debt obligation) in return for insurance premiums payable periodically by the buyer of the C.D.S. (the insured). Most probably the premium charged by the BBP Trio is below the premium that would be charged in the C.D.S. market, or else Citigroup would have bought the asset insurance there.

In other words, the insurance premium that the BBP Trio is charging to Citigroup probably embodies just one more subsidy to (1) a management that begot the very mess in which the firm now finds itself, (2) the shareholders who countenanced that management, and (3) the directors that were charged with supervising the management. We now hope, with all that cash and those subsidies thrown at it, Citigroup’s management will be moved to make loans once again to Main Street.

Don’t count on it.

Source: newyorktimes.com

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