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Paulson's monster

• Robert Peston
• 21 Sep 08, 12:56 PM

More details have been disclosed overnight about the new state-owned institution being created by Hank Paulson, the US Treasury Secretary, to purchase distressed US mortgages and securities manufactured from those mortgages.

He wants to raise $700bn for this institution, from the sale of US government bonds in tranches of $50bn. That $700bn is about 35% more than the entire annual budget of the US defence department.

And to facilitate the funding, the statutory ceiling on US public debt is being raised from $10.6 trillion to $11.3 trillion a rise of 6.6% - which puts this ceiling at around a fifth less than the entire annual output of the US economy.

According to the draft proposal put to Congress, Paulson would have very wide discretion in deciding precisely what "mortgage-related assets" could be purchased, but they would include "residential or commercial mortgages and any securities, obligations or other instruments that are based on or related to such mortgages".

Banks eligible to sell to this Treasury-owned bank would be banks with significant operations in the US - so, for example, Royal Bank of Scotland (which has a big retail business in the US) and Barclays would be able to dump their toxic mortgage-related investments on the Treasury, but HBOS and Lloyds TSB (which have less of the nasty stuff, in any case) probably wouldn't be able to do so.

As for the mechanism for buying the poisonous assets from banks, a fact sheet put out by the US Treasury talks about using reverse auctions.

This would mean that commercial banks would bid to sell their assets to the Government, and the winning bid - and the clearing price for all bids - would be the lowest price put forward by the banks (hence the "reverse" tag).

The merit in using a reverse auction is that it should provide better protection for taxpayers from future losses, because the Treasury-owned bank would be paying the lowest price acceptable to banks for the assets.

However, the worry would be the one I highlighted in my note of yesterday: if the selling price of these impaired assets was determined by what the most stressed banks would accept, that could force all banks into further writedowns, which in turn would further undermine their balance sheets, and thus enfeeble rather than strengthen the banking system.

So just how big a bank would Paulson's baby turn out to be?

Well if it were buying mortgages and asset-backed securities at somewhere between 10 and 50 cents in the dollar - which is not an unreasonable assumption based on the latest markdowns by banks - it would end up owning assets with an origination value of well over $2,000bn (or $2 trillion).

That would make it about the same size as HSBC, on one measure - so something of a monster.

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