While a proposal to authorize the Treasury to buy $700 billion in mortgage backed securities failed today, the FDIC guaranteed a $312 billion Wachovia portfolio with a healthy share of mortgage backed securities, in connection with a Citigoup purchase of Wachovia's banking business.
The Federal Deposit Insurance Corporation (FDIC) has agreed to provide loss protection in connection with approximately $312 billion of mortgage-related and other Wachovia assets. Citi is responsible for the first $30 billion of losses on this portfolio, and expects to record these expected losses under purchase accounting upon closing of the transaction. Citi is also responsible for the next $12 billion in losses up to a maximum of $4 billion per year for the next three years. Citi has also agreed to issue to the FDIC preferred stock and warrants with a combined value of approximately $12 billion. The FDIC has agreed to be responsible for any further losses on this portfolio.
In its role as a "loss protector," the FDIC would have no assets to sell to cover a loan from the Treasury, so this could turn into a tax funded bailout if the portfolio goes very badly.
The FDIC has a reserve of about $40-$50 billion to cover losses, beyond that the FDIC would have to borrow against its line of credit with the Treasury. If the guaranteed portfolio drops 11% or less, FDIC loses nothing, and Citibank takes the loss. But, if the guaranteed portfolio loses more, Citibank loses any incentive to control the losses, and the FDIC exposure could be huge.
There are few details at this stage on the amount of risk involved in the FDIC guaranteed portfolio. If these mortgage backed securities are mostly convention, fixed rate paper, the risk could be very modest. If these are packed with subprime loans, the loss could be huge.
The FDIC brokered deal will turn over Wachovia's banking business and most of its debts (including apparently all of its bonds) to Citigroup, while leaving its non-banking operations as a free standing, presumably long term debt free, publicly held investment company.