Order Code RS22969
October 10, 2008
The Emergency Economic Stabilization Act’s
Insurance for Troubled Assets
Baird Webel
Analyst in Financial Economics
Government and Finance Division
Summary
Many observers trace the root cause of recent instability in financial markets to
uncertainty surrounding the value of widely held securities that are based on mortgages
and mortgage-related assets. Losses on these securities have led to the unexpected and
relatively sudden failure of several large financial institutions. Credit markets have
nearly frozen at times as financial institutions demanded very high interest rates on
traditionally routine short-term lending. While there is limited evidence that financial
turmoil has caused widespread damage in the broader economy, it is feared that
significant real economic effects may be forthcoming, particularly if credit markets
remain frozen.
Responding to these economic fears, the House took up the Emergency Economic
Stabilization Act of 2008 (EESA) as an amendment to H.R. 3997 on September 29,
2008. This amendment failed by a vote of 205-228. Following this, the Senate took up
a bill of the same title with a number of additions and passed it by a vote of 74-25 on
October 1, 2008, as an amendment to H.R. 1424. On October 3, 2008, the House passed
the amended version of H.R. 1424 by a vote of 263-171. The President signed the bill
into law, P.L. 110-343, on the same day. Both versions of the act intend to address
recent instability in the financial market through a variety of measures, including an
insurance program for “troubled assets.” This insurance program would provide U.S.
government guarantees for some of the securities that are perceived as being at the root
of the current financial instability. This report briefly summarizes and analyzes the
insurance program contained in the enacted version of the EESA; it will be updated as
warranted by legislative and market events.
Introduction
Over the past two decades, mortgages have increasingly been funded indirectly
through asset-backed securities and non-bank lenders, rather than directly through
deposits in the traditional banking model. In most cases, once a mortgage was made, the
mortgage was sold by the entity that originated the loan to another institution, which

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pooled a large number of these loans together. From this pool of loans, the institution
then issued securities whose returns were based on the payments made on the underlying
mortgages in the pool. For a variety of market and regulatory reasons, these mortgage-
backed securities (MBS) became widely held by nearly every financial institution in the
United States and in many institutions worldwide. In addition to the securities directly
backed by mortgages, financial institutions created numerous other complex securities and
derivatives based on the initial MBS. These secondary products, such as collateralized
debt obligations (CDO) and credit default swaps (CDS) were also very widely held.
In 2006 and 2007, the rates of default and non-payment by mortgages holders
increased significantly. This, in turn, caused the securities and derivatives ultimately
based on these mortgages to lose value. In some cases, securities thought to be safe were
completely wiped out. These losses have rippled through the financial system, causing
problems for institutions in a number of unexpected ways as well as stress to the general
financial system. The failure of large financial institutions including Bear Stearns,
IndyMac, Lehman Brothers, AIG, and Wachovia was largely due to this turmoil. Due
largely to the uncertainty about what future mortgage default rates will be, as well as who
is currently holding MBS, financial markets have nearly frozen at various points in time
since August 2007. On September 19, 2008, the Secretary of the Treasury called for a
broad program of financial intervention to stabilize markets. The Treasury proposal
called for government purchases of up to $700 billion in mortgage-related securities, in
the hope that, by partially purging the system of these troubled assets, normal functioning
of the financial markets could be restored.
The idea of broad asset purchases, as in the Treasury plan, is only one of a number
of methods that could be used to address the uncertainties regarding mortgage-related
assets. Among the other concepts put forward in Congress has been that of a federal
guarantee program to insure mortgage-related assets. Insurance on municipal securities
has been issued by private insurers since the 1970s, and in the past decade many insurers
broadened their insurance offerings to include mortgage-related securities. Most of the
insurers specializing in this type of insurance have suffered major losses and ratings
agency downgrades in the last year.
As a legislative proposal, a federal insurance program for “troubled assets” appeared
in the Emergency Economic Stabilization Act of 2008 (EESA), a House amendment to
H.R. 3997, which failed in the House on a vote of 205-228 on September 29, 2008.
Another version of the EESA, which included the original EESA plus several other
provisions not in the first bill,1 was offered on October 1 in the Senate as an amendment
to the previously passed H.R. 1424. The amended version of H.R. 1424 was approved
by a Senate vote of 74-25; it was then taken up by the House and passed by a vote of 263-
171 on October 3, 2008. The President signed the amended version of H.R. 1414, now
P.L. 110-343, the same day as House passage.
1 Additional provisions included a temporary increase in the limit on FDIC-provided depository
insurance as well as extensive tax provisions that had previously been considered by one or both
Houses of Congress.

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Federal Insurance of Troubled Assets
Section 102 of P.L. 110-343 provides that if the Secretary of the Treasury creates a
program to purchase troubled assets (as authorized in Section 101), he or she shall also
create a program to guarantee troubled assets. Troubled assets under the bill are defined
as “residential or commercial mortgages and any securities, obligations, or other
instruments that are based on or related to such mortgages.”2 The underlying mortgages
in question must have been originated before March 14, 2008. The bill also gives the
Secretary of the Treasury, after consultation with the Chairman of the Federal Reserve,
the authority to purchase any other financial instrument necessary to promote market
stability. Congress must be notified of such a purchase, but explicit approval from
Congress is not needed.
Aside from the requirement to establish the program, the Secretary of the Treasury
has relatively broad authority as to the structure of the program. He or she may not
guarantee the prompt payment of more than 100% of the insured securities’ interest and
principal payments — 100% is typical of bond insurance in the private sector — but the
Secretary is free to guarantee less than 100% as well. Aggregate premiums for the
insurance are required to cover the expected losses from the insurance program, and the
Secretary has the authority to base individual premiums on the risk of the security to be
covered, but there is no requirement that premiums be risk-based. The combined size of
the purchase and insurance programs for troubled assets authorized in the bill is limited
to $700 billion, but the Secretary of the Treasury is free to decide what percentage of the
overall amount the two programs occupy.
Impact of the Proposed Program
Given the authority that the Secretary has to shape the program, along with the host
of other uncertainties in the current financial climate, it is difficult to assess the potential
impact of the federal guarantee program. In theory, such a program could have a
significant impact by improving confidence in the financial markets. In previous market
experience with private bond insurance, once a security was guaranteed, it was generally
treated as a security with the same credit rating as the insurer. Thus, for example, a single
A rated municipal sewer authority could issue a bond that would be treated as AAA if the
bond was then insured by a AAA-rated insurer. If the federal government were to issue
a 100% guarantee on a mortgage-backed security, even one backed by subprime loans
with a high default rate, the market may treat it essentially as a U.S. Treasury security,
which is widely considered to be the safest and most liquid security that can be held.3 If
2 P.L. 110-343, Section 3.
3 There is potentially an important difference between Treasury securities and securities that
might be guaranteed under this insurance program. Treasury securities are clearly backed by the
“full faith and credit” of the U.S. government, and are paid for out of the general taxing authority
of the federal government. Under P.L. 110-343, claims on the troubled asset insurance program
are to be paid for out of the premiums collected. There is no explicit authority for the program
to borrow from the Treasury as with other federal insurance programs, such as flood insurance.
If the claims exceed the funds collected through premiums, it is unclear how these claims would
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this occurred for a wide swath of the MBS that are currently illiquid and looked at with
great skepticism by the markets, theory would suggest that it would restore the confidence
that has been absent in the financial markets in recent weeks.
While the asset purchase plan also contained in P.L. 110-343 could provide the same
widespread boost to market confidence, an insurance program may have advantages
compared with the purchase plan. The insurance plan would result in little or no
government ownership of assets with the attendant questions of how these assets are then
to be disposed of. The insurance plan, as structured, would be self-financing. There are
no provisions in the plan for the outlay of taxpayer monies. An insurance program would
also avoid accounting problems that could emerge if the purchasing plan results in asset
sales at significant discounts to previous prices. Under mark-to-market accounting rules
such asset sales may trigger accounting losses in other companies holding similar
securities and might even threaten the solvency of other financial institutions. Such hoped
for benefits of the insurance program, however, may also be offset to some degree by
practical questions concerning how the plan might actually work. Many of these
questions revolve around the overall cost of the insurance program and the individual
premiums to be charged for the government guarantee.
Providing guarantees for MBS has, in practice, proved a very risky and costly
business over the past year. Most of the bond insurance companies, if they have been able
to remain solvent, have seen their stock prices collapse and their credit ratings
downgraded as losses have mounted on guarantees for MBS. The primary new entrant
to insuring bonds, a subsidiary of Berkshire Hathaway, has specifically indicated it will
not insure such securities.4 It is unclear if and how a federal insurance program would be
able to incur fewer losses than private insurers. If the goal of the program is to improve
the functioning of the financial system by removing the impediments posed by troubled
assets, some would argue the program would not be functioning as intended if the
securities it guaranteed were not suffering losses. Some losses may be avoided by
insuring the mortgage-related securities at less than 100% value, as specifically authorized
in the act. The recent history on mortgage default rates, however, suggests that any
significant guarantee program on mortgage-related securities might incur significant
losses.
The program established in P.L. 110-343 specifies that the losses from the guarantee
program will be covered by the aggregate premiums paid by financial institutions holding
the guaranteed securities. This brings up the most critical point in any insurance endeavor
whether public or private, namely determining the premiums to be charged for the
coverage provided. If the overall premiums are set too low, the endeavor will ultimately
fail as the money coming in will not cover the money going out. If the overall premiums
are set too high, in this case, fewer mortgage-related securities would be insured than
would be possible. This would presumably be counter to the act’s goal of restoring
liquidity and stability to the U. S. financial system. Setting optimal premiums for
mortgage-related securities would require an accurate estimate of what mortgage default
3 (...continued)
be paid.
4 See CRS Report RL34364, Bond Insurers: Issues for the 110th Congress, by Baird Webel and
Darryl E. Getter.

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rates will be around the country in the future and how these default rates will affect the
payment streams on mortgage-related securities. The inability to make such accurate
estimates is identified by many to be at the heart of the uncertainty bedeviling the
financial system today.
In addition to the question of setting overall premiums so the program remains
solvent, the question of setting individual premiums for specific securities is also
challenging. The bill includes the authority, but not requirement, to vary premiums
“according to the credit risk associated with the particular troubled asset that is being
guaranteed.” If individual premiums are not risk-based, then the program may suffer from
adverse selection, meaning that the program will attract primarily securities that are
relatively high risk. If these high risk securities result in higher losses than anticipated,
the overall premiums would ultimately have to be raised to keep the program solvent.
Higher premiums would likely result in fewer institutions participating in the program and
the remaining guaranteed securities being on the whole higher risk than before. If
individual premiums are to be risk-based, the insurance will encounter the problems
mentioned above with regard to estimating future mortgage default rates. Indeed the
difficulties in estimating the impact on individual securities, and thus establishing
individual risk-based premiums, would be much greater than simply estimating the overall
amount of premiums needed for the program to remain solvent.
Conclusion
Many argue that a central driver of the recent turmoil in financial markets has been
uncertainty and fear regarding mortgage-related securities that are widely held in the
financial system. Among the mechanisms recently passed by Congress to address these
problems is a federal program to insure troubled assets. Private insurance to enhance the
credit-worthiness and attractiveness of securities has operated for more than 30 years.
This record shows that an insurance mechanism can have a role to play in the securities
marketplace. Recent private experience insuring mortgage-related assets, however, has
been negative; such insurers have experienced large losses and many have faced
difficulties remaining solvent. The Department of the Treasury will face significant
practical challenges as it implements the federal program to insure troubled assets.
Particular difficulties include ensuring the overall solvency of the program through
sufficient aggregate premiums and setting individual premiums commensurate with the
risks posed by mortgage-related securities.

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