The US government has provided over $150bn to AIG, which insured quite a lot of credit / investments that banks made over the past decade through new financial products (derivatives). Interesting that the US taxpayer became the insurer of last resort (yet again) (see Economist's View and FT), but without the benefit of collecting the insurance premiums paid by these banks over the past few years. Instead these went to private individuals and companies in terms of excess profits. Many other governments have also guarenteed certain types of credit transactions. While the discussion below focusses only on the US situation, the argument ould easily be adopted (with some minor adjustments) to the situation in other countries consumed by the financial crisis (e.g. UK, France, Italy, etc).
Just like the FDIC is insurer of deposits at registered banks and collects regular insurance premiums from them, in future the US would need to establish a nationalised insurance agency for the shadow banking system - a similar legal agency such as Fannie Mae or Freddie Mac or the FDIC. Given the extent to which AIG has fulfilled this role thus far, the easiest would be for AIG to be nationalised and later reorganised into a federal agency. Obviously, the other, non-essential arms of AIG (i.t.o. the proposed agency) should be privatised before becoming a federal agency. Also, this should be done in an environment in which derivatives are regulated. In addition, there should be a mandatory testing off new financial products before they are released into the market (similar to new medicines and the FDA) to identify its likely systemic impact, it is likely cost of bailout and thus correctly pricing the insurance premiums.
This agency will rationalise the system in identifying all the bogus derivative products on the market and getting them out of the system (i.e. the 95% of gambling/betting products not adding value to the system but siphoning off massive amounts). It should greatly assist in getting the credit markets working again with credit insurance becoming available again (i.e. assist in correctly pricing risk in the provision of credit). It could also regulate competition in the various derivative markets to reduce the probability that a single entity become so big / entangled to be too big to fail and cause the system to fail. Also, it will assist the Fed in later getting rid of all its new and questionable assets from its balance sheet.
As insurer of last resort, this agency will necessarily have to develop a type of federal insurance fund (FIF) (similar to the FDIC funds). I see this agency buying up all existing toxic assets (i.e. "insurance of insurance" / financial gambling products) by using funding from Treasury. All of TARP1 and any future funding (maybe up to US$3/4 trillion).
Unfortunately, given the existing need for immediate funds, the FIF will be massively in the red. Some of the products it will be able to sell later recovering some of the money provided by the fund - what the Treasury / Fed is hoping will happen in future. This could be above, at or below existing market values. However, many products are so worthless that they will have to be written off completely - the losses everyone knows about but the Fed dont want to acknowledge and banks dont want to write off otherwise they will be insolvent. The likely outcome is that the FIF will be significantly negative into hundreds of billions of dollars if not more for a number of years.
However, by collecting regulated / enforcable insurance premiums from the finance industry in future (to the value of millions and billions of dollars p.a.), the finance industry will ultimately pay most of the clean-up costs of the current crisis itself. This would reduce the future costs to the taxpayer. It will likely be off the balance sheet of the Federal Budget (e.g. Social Security funds), with only annual costs borne by the taxpayer on the Budget over the next few years.
While the Fed and other central banks have pumped massive amounts of cash into the financial systems over the past 6 months, little is being done to reduce the risk of providing credit. This proposal will greatly assist in reducing credit risks and getting banks and other financial institutions to undertake lending again.
