Many observers trace the root cause of recent instability in financial markets to uncertainty surrounding the value of widely held securities that are based on mortgages and mortgage-related assets. The introduction of the Emergency Economic Stabilization Act of 2008 (EESA) was designed to address said financial instability through a variety of measures, including an insurance program for "troubled assets." This report briefly summarizes and analyzes the insurance program contained in the enacted version of the EESA

Webel, Baird

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The Emergency Economic Stabilization Act’s Insurance for Troubled Assets

Order Code RS22969October 10, 2008The Emergency Economic Stabilization Act’sInsurance for Troubled AssetsBaird WebelAnalyst in Financial EconomicsGovernment and Finance DivisionSummaryMany observers trace the root cause of recent instability in financial markets touncertainty surrounding the value of widely held securities that are based on mortgagesand mortgage-related assets.  Losses on these securities have led to the unexpected andrelatively sudden failure of several large financial institutions.  Credit markets havenearly frozen at times as financial institutions demanded very high interest rates ontraditionally routine short-term lending.  While there is limited evidence that financialturmoil has caused widespread damage in the broader economy, it is feared thatsignificant real economic effects may be forthcoming, particularly if credit marketsremain frozen.Responding to these economic fears, the House took up the Emergency EconomicStabilization Act of 2008 (EESA) as an amendment to H.R. 3997 on September 29,2008.  This amendment failed by a vote of 205-228.  Following this, the Senate took upa bill of the same title with a number of additions and passed it by a vote of 74-25 onOctober 1, 2008, as an amendment to H.R. 1424.  On October 3, 2008, the House passedthe amended version of H.R. 1424 by a vote of 263-171.  The President signed the billinto law, P.L. 110-343, on the same day.  Both versions of the act intend to addressrecent instability in the financial market through a variety of measures, including aninsurance program for “troubled assets.”  This insurance program would provide U.S.government guarantees for some of the securities that are perceived as being at the rootof the current financial instability.  This report briefly summarizes and analyzes theinsurance program contained in the enacted version of the EESA; it will be updated aswarranted by legislative and market events.IntroductionOver the past two decades, mortgages have increasingly been funded indirectlythrough asset-backed securities and non-bank lenders, rather than directly throughdeposits in the traditional banking model.  In most cases, once a mortgage was made, themortgage was sold by the entity that originated the loan to another institution, whichCRS-21 Additional provisions included a temporary increase in the limit on FDIC-provided depositoryinsurance as well as extensive tax provisions that had previously been considered by one or bothHouses of Congress. pooled a large number of these loans together.  From this pool of loans, the institutionthen issued securities whose returns were based on the payments made on the underlyingmortgages in the pool.  For a variety of market and regulatory reasons, these mortgage-backed securities (MBS) became widely held by nearly every financial institution in theUnited States and in many institutions worldwide.  In addition to the securities directlybacked by mortgages, financial institutions created numerous other complex securities andderivatives based on the initial MBS.  These secondary products, such as collateralizeddebt obligations (CDO) and credit default swaps (CDS) were also very widely held.In 2006 and 2007, the rates of default and non-payment by mortgages holdersincreased significantly.  This, in turn, caused the securities and derivatives ultimatelybased on these mortgages to lose value.  In some cases, securities thought to be safe werecompletely wiped out.  These losses have rippled through the financial system, causingproblems for institutions in a number of unexpected ways as well as stress to the generalfinancial system.  The failure of large financial institutions including Bear Stearns,IndyMac, Lehman Brothers, AIG, and Wachovia was largely due to this turmoil.  Duelargely to the uncertainty about what future mortgage default rates will be, as well as whois currently holding MBS, financial markets have nearly frozen at various points in timesince August 2007.  On September 19, 2008, the Secretary of the Treasury called for abroad program of financial intervention to stabilize markets.  The Treasury proposalcalled for government purchases of up to $700 billion in mortgage-related securities, inthe hope that, by partially purging the system of these troubled assets, normal functioningof the financial markets could be restored.The idea of broad asset purchases, as in the Treasury plan, is only one of a numberof methods that could be used to address the uncertainties regarding mortgage-relatedassets.  Among the other concepts put forward in Congress has been that of a federalguarantee program to insure mortgage-related assets.  Insurance on municipal securitieshas been issued by private insurers since the 1970s, and in the past decade many insurersbroadened their insurance offerings to include mortgage-related securities.  Most of theinsurers specializing in this type of insurance have suffered major losses and ratingsagency downgrades in the last year.  As a legislative proposal, a federal insurance program for “troubled assets” appearedin the Emergency Economic Stabilization Act of 2008 (EESA), a House amendment toH.R. 3997, which failed in the House on a vote of 205-228 on September 29, 2008.Another version of the EESA, which included the original EESA plus several otherprovisions not in the first bill,1 was offered on October 1 in the Senate as an amendmentto the previously passed H.R. 1424.  The amended version of H.R. 1424 was approvedby a Senate vote of 74-25; it was then taken up by the House and passed by a vote of 263-171 on October 3, 2008.  The President signed the amended version of H.R. 1414, nowP.L. 110-343, the same day as House passage.CRS-32  P.L. 110-343, Section 3.3 There is potentially an important difference between Treasury securities and securities thatmight be guaranteed under this insurance program.  Treasury securities are clearly backed by the“full faith and credit” of the U.S. government, and are paid for out of the general taxing authorityof the federal government.  Under P.L. 110-343, claims on the troubled asset insurance programare to be paid for out of the premiums collected.  There is no explicit authority for the programto borrow from the Treasury as with other federal insurance programs, such as flood insurance.If the claims exceed the funds collected through premiums, it is unclear how these claims would(continued...)Federal Insurance of Troubled AssetsSection 102 of P.L. 110-343 provides that if the Secretary of the Treasury creates aprogram to purchase troubled assets (as authorized in Section 101), he or she shall alsocreate a program to guarantee troubled assets.  Troubled assets under the bill are definedas “residential or commercial mortgages and any securities, obligations, or otherinstruments that are based on or related to such mortgages.”2  The underlying mortgagesin question must have been originated before March 14, 2008.  The bill also gives theSecretary of the Treasury, after consultation with the Chairman of the Federal Reserve,the authority to purchase any other financial instrument necessary to promote marketstability.  Congress must be notified of such a purchase, but explicit approval fromCongress is not needed.Aside from the requirement to establish the program, the Secretary of the Treasuryhas relatively broad authority as to the structure of the program.  He or she may notguarantee the prompt payment of more than 100% of the insured securities’ interest andprincipal payments — 100% is typical of bond insurance in the private sector — but theSecretary is free to guarantee less than 100% as well.  Aggregate premiums for theinsurance are required to cover the expected losses from the insurance program, and theSecretary has the authority to base individual premiums on the risk of the security to becovered, but there is no requirement that premiums be risk-based.  The combined size ofthe purchase and insurance programs for troubled assets authorized in the bill is limitedto $700 billion, but the Secretary of the Treasury is free to decide what percentage of theoverall amount the two programs occupy.Impact of the Proposed ProgramGiven the authority that the Secretary has to shape the program, along with the hostof other uncertainties in the current financial climate, it is difficult to assess the potentialimpact of the federal guarantee program.  In theory, such a program could have asignificant impact by improving confidence in the financial markets.  In previous marketexperience with private bond insurance, once a security was guaranteed, it was generallytreated as a security with the same credit rating as the insurer.  Thus, for example, a singleA rated municipal sewer authority could issue a bond that would be treated as AAA if thebond was then insured by a AAA-rated insurer.  If the federal government were to issuea 100% guarantee on a mortgage-backed security, even one backed by subprime loanswith a high default rate, the market may treat it essentially as a U.S. Treasury security,which is widely considered to be the safest and most liquid security that can be held.3  IfCRS-43 (...continued)be paid.4 See CRS Report RL34364, Bond Insurers: Issues for the 110th Congress, by Baird Webel andDarryl E. Getter.this occurred for a wide swath of the MBS that are currently illiquid and looked at withgreat skepticism by the markets, theory would suggest that it would restore the confidencethat has been absent in the financial markets in recent weeks.  While the asset purchase plan also contained in P.L. 110-343 could provide the samewidespread boost to market confidence, an insurance program may have advantagescompared with the purchase plan.  The insurance plan would result in little or nogovernment ownership of assets with the attendant questions of how these assets are thento be disposed of.  The insurance plan, as structured, would be self-financing.  There areno provisions in the plan for the outlay of taxpayer monies.  An insurance program wouldalso avoid accounting problems that could emerge if the purchasing plan results in assetsales at significant discounts to previous prices.  Under mark-to-market accounting rulessuch asset sales may trigger accounting losses in other companies holding similarsecurities and might even threaten the solvency of other financial institutions.  Such hopedfor benefits of the insurance program, however, may also be offset to some degree bypractical questions concerning how the plan might actually work.  Many of thesequestions revolve around the overall cost of the insurance program and the individualpremiums to be charged for the government guarantee.Providing guarantees for MBS has, in practice, proved a very risky and costlybusiness over the past year.  Most of the bond insurance companies, if they have been ableto remain solvent, have seen their stock prices collapse and their credit ratingsdowngraded as losses have mounted on guarantees for MBS.  The primary new entrantto insuring bonds, a subsidiary of Berkshire Hathaway, has specifically indicated it willnot insure such securities.4  It is unclear if and how a federal insurance program would beable to incur fewer losses than private insurers.  If the goal of the program is to improvethe functioning of the financial system by removing the impediments posed by troubledassets, some would argue the program would not be functioning as intended if thesecurities it guaranteed were not suffering losses.  Some losses may be avoided byinsuring the mortgage-related securities at less than 100% value, as specifically authorizedin the act.  The recent history on mortgage default rates, however, suggests that anysignificant guarantee program on mortgage-related securities might incur significantlosses.The program established in P.L. 110-343 specifies that the losses from the guaranteeprogram will be covered by the aggregate premiums paid by financial institutions holdingthe guaranteed securities.  This brings up the most critical point in any insurance endeavorwhether public or private, namely determining the premiums to be charged for thecoverage provided.  If the overall premiums are set too low, the endeavor will ultimatelyfail as the money coming in will not cover the money going out.  If the overall premiumsare set too high, in this case, fewer mortgage-related securities would be insured thanwould be possible.  This would presumably be counter to the act’s goal of restoringliquidity and stability to the U. S. financial system.  Setting optimal premiums formortgage-related securities would require an accurate estimate of what mortgage defaultCRS-5rates will be around the country in the future and how these default rates will affect thepayment streams on mortgage-related securities.  The inability to make such accurateestimates is identified by many to be at the heart of the uncertainty bedeviling thefinancial system today.In addition to the question of setting overall premiums so the program remainssolvent, the question of setting individual premiums for specific securities is alsochallenging.  The bill includes the authority, but not requirement, to vary premiums“according to the credit risk associated with the particular troubled asset that is beingguaranteed.”  If individual premiums are not risk-based, then the program may suffer fromadverse selection, meaning that the program will attract primarily securities that arerelatively high risk.  If these high risk securities result in higher losses than anticipated,the overall premiums would ultimately have to be raised to keep the program solvent.Higher premiums would likely result in fewer institutions participating in the program andthe remaining guaranteed securities being on the whole higher risk than before.  Ifindividual premiums are to be risk-based, the insurance will encounter the problemsmentioned above with regard to estimating future mortgage default rates.  Indeed thedifficulties in estimating the impact on individual securities, and thus establishingindividual risk-based premiums, would be much greater than simply estimating the overallamount of premiums needed for the program to remain solvent.ConclusionMany argue that a central driver of the recent turmoil in financial markets has beenuncertainty and fear regarding mortgage-related securities that are widely held in thefinancial system.  Among the mechanisms recently passed by Congress to address theseproblems is a federal program to insure troubled assets.  Private insurance to enhance thecredit-worthiness and attractiveness of securities has operated for more than 30 years.This record shows that an insurance mechanism can have a role to play in the securitiesmarketplace.  Recent private experience insuring mortgage-related assets, however, hasbeen negative; such insurers have experienced large losses and many have faceddifficulties remaining solvent.  The Department of the Treasury will face significantpractical challenges as it implements the federal program to insure troubled assets.Particular difficulties include ensuring the overall solvency of the program throughsufficient aggregate premiums and setting individual premiums commensurate with therisks posed by mortgage-related securities.

The Emergency Economic Stabilization Act's Insurance for Troubled Assets

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The Emergency Economic Stabilization Act's Insurance for Troubled Assets

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