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Taxpayers recapitalise banks

• Robert Peston
• 23 Sep 08, 04:45 PM

There can be no doubt any longer that the secretary's proposal to buy bad mortgage debts from banks represents the mother of all bail-outs.

The cat was let out of the bag today by the Chairman of the , Ben Bernanke, in testimony to the .

Chairman Bernanke said that the Treasury would attempt to buy these debts from banks at close to their "hold-to-maturity" value, not the market value.

In practice, it means banks who sell their debts to the Treasury would receive cash equivalent to something like twice the value in their books of these poisonous assets.

In other words banks would book a profit from selling to taxpayers!

It would represent a massive injection of new capital into the US banking system - for which taxpayers would receive nothing in return, except for the assurances from Mr Paulson and Chairman Bernanke that their banking system would not collapse.

US lawmakers may agree to this jaw-dropping proposal. But it won't be an easy sell.

UPDATE, 17:20PM: To elucidate, the "hold-to-maturity" is an estimate of what a loan will repay over the full life of the loan, as opposed to the trading price in the market.

The current trading or market prices for mortgage-backed securities and their more toxic cousins in the CDO world are partly low because the markets aren't functioning: there are no buyers.

So arguably the market prices are too low.

Even so, this seizing up of markets is widely seen as the banks' fault, for the way they lent during the bubble years as if there was no tomorrow.

And to reiterate the big point: Paulson and Bernanke are asking Congress to legislate to allow them to use taxpayers' money to generate massive profits for the likes of Citigroup, Morgan Stanley and Merrill, by buying their poisonous assets at far above what the market says these assets are worth.

I find it difficult to believe that Congress will give its assent, unless there is a massive tit for tat - which could be stakes for taxpayers in the banks, or the wholesale sackings of bank executives, or some other form of spanking.

Actually, just a plain sorry from the banks would probably help.

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The next accident

• Robert Peston
• 23 Sep 08, 08:02 AM

New York State wants to bring law and order to the last wild frontier of global finance, the credit default swaps market.

It's yet another attempt to close a stable door after a galloping herd has not only bolted but has already crossed the state line.

Credit default swaps are - in essence - contracts to insure debt, especially debt in the form of bonds, against the risk of default.

They began life as a sensible initiative by banks to reduce the risks they were running in lending to companies. Banks used them to lay off the risks of default to specialist insurers and other financial firms.

But as with all good things in global finance, especially the unregulated things, the market then binged on these credit derivatives.

Their use exploded with the boom in collateralised debt obligations made out of subprime loans, because the vendors of these toxic securities took out credit-default-swap contracts to secure cherished AAA ratings - or to turn poo into gold (most of it's since turned back into poo, occasioning great pain for the banking system).

And, in the corporate markets, credit default swaps became an instrument of pure speculation. If hedge funds wanted to speculate on the fortune of a big business, they would often buy and sell these credit derivatives as an alternative to shares.

Why?

Well this was - for a while at least - a huge, liquid and unregulated market, a true Wild West, almost free from the nosey attention of sheriffs and regulators who take an annoying interest in what goes on in stock markets.

Anyway the notional value of extant credit derivatives, in terms of the underlying value of the debt insured, was something over $60,000bn at the end of 2007, or more than five times the value of the entire US economy.

However many analysts say the better measure of the size of market is the $2,000bn fair value of outstanding contracts - because that's an attempt to assess potential losses and gains.

Both numbers are big, even if one of those falls into the too-big-to-fathom category.

Perhaps the more important point is that over just the past three years, the size of the market has increased by 15 times.

Which simply tells you that a lot of stupid contracts have been written at the wrong price, since in the two years to August last year most bankers and financial firms were pricing financial risk as though it were a myth from a bygone age.

Anyway it was AIG's exposure to credit derivative contracts that did it in just a few days ago: one of its subsidiaries had to find a colossal amount of cash in a hurry under its credit derivative contracts, because of a contractual requirement to post collateral after its credit-worthiness was marked down by rating agencies.

All of which is to explain why the issued a statement yesterday saying that his state will regard as insurance, in a formal sense, those contracts sold to investors who own bonds they want to protect from default.

It will therefore require proof from the entities selling the insurance that they have the resources to actually pay possible claims under the relevant contracts.

Doh!

I'd laugh if I didn't want to cry.

Paterson is implying that many of the writers of credit default swaps don't have the means to make good on their liabilities, that they were taking a punt, hoping to make easy money from insurance they thought would never be claimed on.

It's one of those "emperor's new clothes moments" that leaves me almost lost for words (almost).

To state the bloomin' obvious (as is my wont), we should be worried about this because we are entering a pronounced economic slowdown in which many companies will have difficulties servicing their debt.

And so we will start to see a raft of claims under credit derivative contracts, to add to those already triggered by the collapses of Lehman, Fannie and Freddie.

If the insurers can't pay, well that could lead to losses and pain all over the place, for hedge funds, for pension funds and for banks - which may still be living in the fools' paradise of thinking that their balance sheets are stronger than they are, thanks to all that lovely insurance they've taken out.

PS. Yesterday was a truly horrific day for the US Treasury.

First it learned that investors aren't in love with its bank bailout plan, because of the way that all those liabilities damage the credit-worthiness of the US.

Second, the opposition of influential legislators to the $1.1 trillion bailout has demonstrated in the reaction of markets that no bailout would be worse for the financial system than an unaffordable bailout.

It's going to be another hairy day.

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