The nonpartisan Congressional agency estimated that taxpayers had already lost 53 percent of the government’s $40 billion investment in American International Group , the giant insurance company that had been insuring tens of billions of dollars in junk mortgage-backed securities against default. As part of the rescue, the government helped A.I.G. buy back billions in mortgage securities that it had insured.
As the new Obama economic team pondered a new approach, one alternative, though an unlikely one, would be to revive Mr. Paulson’s original idea of buying troubled assets through an auction process. The potential virtue of auctions is that they could get closer to establishing a true market value for the assets.
But the drawback is that many of the securities are so arcane and complex that they are unlikely to generate the volume of bidding needed to establish a real market price.
A second approach, which Mr. Paulson had already used in a second round of bailouts for Citigroup and Bank of America , is to “ring-fence” the bad assets by providing federal guarantees against losses, and separating the assets from the rest of a bank’s balance sheet.
The virtue of that approach is that it costs relatively little money up front, because the government is essentially providing insurance coverage.
The danger is that the potential cost to taxpayers of federal guarantees can be even less transparent than other approaches. As a result, the final costs to taxpayers could be huge. Indeed, the guarantees would put the government in the same business that led to immense losses from mortgage-backed securities: credit-default swaps.
In its recent report, the Congressional Budget Office estimated the $20 billion that the Treasury spent in November to guarantee $306 billion of toxic assets by Citigroup will cost taxpayers $5 billion — a 26 percent subsidy.
William Seidman, a former chairman of the Federal Deposit Insurance Corporation who was closely involved with the bailout of savings-and-loan institutions in the 1990s, said the government should simply take control of the banks it tries to rescue. “When we did things like this, we took the banks over,” Mr. Seidman. “This is a huge, undeserved gift to the present shareholders.”
One big difference between today and the 1990s is that the government back then was seizing entire failed institutions. On paper, at least, the banks in trouble today are still viable.
That leaves the third and increasingly talked-about approach — have the government buy up the toxic assets and put them into a government-financed “bad bank” or an “aggregator bank.”
The immediate virtue of the bad bank is that the remaining “good bank” would have a clean balance sheet, unburdened by the uncertainty of future losses from bad loans and securities.
Richard Berner, chief economist at Morgan Stanley, described the “bad bank” strategy as the “least bad” of available options. The main advantage, Mr. Berner said, was that the government would have to decide how much it was willing to pay for the toxic assets. In turn, that would make it easier for the public to figure out whether the government was overpaying.
Banks may not want that kind of openness, because accurately valuing the toxic assets could force many to book big losses, admit their insolvency and shut down.