Another weekend, another bank rescue. On Sunday night, the US Treasury moved to shore up Citigroup. There was no choice - the banking giant could not be allowed to keep stumbling. The rescue seems to have been generous to Citi¬group, but the insurance scheme it uses is a model that deserves wider consideration.
Shaken by the announcement by Hank Paulson, the US Treasury secretary, that the troubled asset relief programme would not buy distressed mortgage assets, investors gave Citigroup a wide berth. Last week, its share price fell by more than 60 per cent.
A loss of confidence in a vast bank with retail and investment banking businesses is dangerous; Citigroup is systemically important several times over. The US Treasury acted in similar fashion to the Swiss government's rescue of UBS. It injected $20bn of capital from the Tarp into the bank - on top of an earlier $25bn - and insured a tranche of its assets.
The terms of the Citigroup rescue seem lenient but the insurance scheme is a good innovation. The government is guaranteeing the bank against losses greater than $29bn on a $306bn portfolio, mostly of distressed mortgage-related assets. The bank paid a fee for this guarantee in preference shares.
Insurance on the value of illiquid securities has been proposed on the Economists' Forum on FT.com by Professors Perry Mehrling, Laurence Kotlikoff and Alistair Milne. It has several desirable attributes.
Underwriting insurance on the value of toxic assets would solve the problems they cause by putting a floor under their value. This would create enormous contingent liabilities that some governments would not be able to bear. The US Tarp would not be able to fund both recapitalisation and insurance.
But an insurance model would be cheaper and easier than trying to buy enough of these securities to allow price discovery. Governments would only need to make good falls in values of insured assets below the agreed limit.
There are, however, practical obstacles. A credible scheme would need measures to prevent banks from holding back on writedowns until they had insurance. Governments would also need to find ways to prevent the banks that use the insurance from engaging in yet-riskier behaviour. The authorities would find it near-impossible to write a tariff for insuring the price of an unpriceable security.
There are no easy answers to this crisis. But governments should consider whether they ought to become the insurer of last resort.
