Way back in the heady days of September, we criticized the original version of TARP because it seemed designed to ensure the government would overpay for toxic assets. Instead, we recommended splitting the transaction into two parts: (a) buy the assets at market (cheap) prices, and (b) explicitly recapitalize the banks. In mid-October, Treasury committed $250 billion to explicit recapitalization, but to all intents and purposes seems committed to using some of the other $450 billion to buy those same toxic assets – at what price is still unclear. (Why they would still bother doing this is also unclear, for that matter.)
Today’s government re-re-bailout of AIG (WSJ article; Yves Smith commentary) can be hard to follow, but one provision is the creation of a new entity with $5 billion from AIG and $30 billion from the government to buy collateralized debt obligations (CDOs). The goal is to buy CDOs that AIG insured (using credit default swaps), because if those CDOs are held by an entity that is friendly to AIG, that entity will no longer demand collateral from AIG. The theory is that in the long run these CDOs will not default and that the new entity will make money on the deal.
The rub is that this entity is planning to pay 50 cents on the dollar for these CDOs. This has two problems. First, 50 cents is almost certainly more than these CDOs are worth on their own (hence the title of this post). If they were really worth 50 cents on the dollar, AIG wouldn’t be having the problems it is having posting collateral; like the original TARP plan, this is an unfounded bet that the market is mispricing these assets. Second, and more bafflingly, the CDS contract is presumably separate from the ownership of the CDO; that is, buying the CDO from the counterparty doesn’t eliminate AIG’s obligation to pay if the CDO defaults, and hence doesn’t serve its stated purpose. If, on the contrary, the CDS contract is contingent on the counterparty holding the CDO, then the CDO is worth a lot more than 50 cents to the counterparty, because it is insured for 100 cents by AIG – and we all know the government isn’t going to let AIG default on those swaps. And no sane counterparty would sell for 50 cents.
Supposedly Treasury had enough time to think about how AIG should be bailed out and this is a better bailout than the original. If it is, I must be missing something.