How is that asset guarantee program s'posed to work?

What makes anyone believe that the troubled banks can afford to pay a reasonable insurance premium on their toxic assets?

For example, the NYT has an article describing one MBS. The MBS is composed of 9,000 second lien mortgages and let's assume that the face value of each averages a little over $50,000 so the total value of the MBS (all tranches) is $500 million. Given the valuation the bank puts on the bond, this may well be the senior tranche, so let's assume the bank has a $250 million senior exposure to losses on these mortgages (i.e. the portfolio needs to lose half its value for the bank to lose a penny). The article states that the bank carries this bond at 97 cents on the dollar or $242.5 million.

However, as anyone who follows the mortgage market knows, second lien loans suffer very badly when housing prices fall dramatically -- because in case of foreclosure there's unlikely to be anything left for the second lien holder. Therefore there is some significant probability that a very large number of these mortgages go into default -- with a recovery of zero.

That's why S&P stated that in their worse case scenario the value of the bank's tranche was worth just 53 cents on the dollar or roughly speaking that only $132.5 million of principal will be recovered (assuming $500 million of loans and a senior tranche of $250 million). Let's say there's a 20% probability that this worse case scenario materializes.

In this case the insurance premium collected by the government insurer of the senior 90% losses of this particular tranche needs to be well over 0.20 ($242.5 - $132.5 - $24.25) = $17.15 million (since a full analysis would not assume that with 80% probability losses are less than $24.25 million and therefore cost the government nothing). In other words for assets of this quality the bank would have to pay significantly more than 7% of the face value of the assets as a premium. Spreading this premium over five years would result in a charge that would have to be well over 1.4% of face value per year.

By contrast in the Bank of America deal that is being used as model for this type of insurance the Fed is charging only 0.2% per year in premiums. Of course, the correct premium depends on what's in the portfolio -- which is not public information -- but it is certainly possible that the Fed is charging only a fraction of a fair market premium for the insurance policy.

If the Fed follows the policy reported in the press of insuring the assets that haven't been written down yet (but like the bond in the NYT article should have been written down), then either the premiums need to be very high relative to the face value of the assets or the government will end up tranferring massive amounts of value to the banks and their shareholders.

In short, if paying banks a fair price for their bad assets is likely to render them insolvent, then charging a fair insurance premium for those assets is also likely to render them insolvent. The only "advantage" of insurance over the purchase of the bad assets is that the government gets to duplicate the outrageously stupid behavior of our bank managers -- they get to make optimistic estimates that indicate that the losses will never show up -- until they do.