A-Z of the Financial Crisis: Toxic asset insurance schemes (AKA Asset Protection Scheme)

What is it?

Asset insurance schemes insure owners of particular assets against making a loss on the assets in question. They are a way of ensuring that the banks which own toxic assets won't have to make big writedowns and therefore won't lose too much money if the price of those assets falls.

As their name indicates, they work like an insurance programme. Governments typically provide the insurance.

For example, if bank A holds toxic assets worth $10bn, the government might guarantee to pay any losses on those assets over $1bn.

Toxic asset insurance schemes are usually presented as alternative solutions to a bad bank. They have two key advantages over them:

1) The toxic assets don't have to be bought upfront - the insurance programme will simply kick in when the assets mature at a lower price, or when mark to market accounting policies require writedowns. As a result, governments don't have to present taxpayers with a large initial bill.

2) Because the toxic assets aren't actually being purchased (as in a bad bank), there is no need to assign them a price. This is advantageous because it's usually difficult to reach an agreement over the price of the assets in question. This can slow the process down considerably.

However, asset insurance programmes also have a few disadvantages. The main ones are -

1) No one really knows how much insuring the assets against future losses will cost. (The UK government admitted as much when it launched the scheme described below.

2) They are not a clean solution. Whereas bad banks segregate and value the toxic assets once and for all, insurance schemes keep the toxic assets on banks' books and only kick in when writedowns are made. This leaves room for a lot of uncertainty, which can lead one bank to distrust another and prolong the credit crunch.

What's it got to do with the financial crisis?

Both the British and American governments have used toxic asset insurance schemes to try to resolve the crisis.

The US government was the first to resort to this method. After Citigroup's share price plummeted precipitously in November 2008, the US government put together a rescue package, which included an insurance programme for $306bn of Citigrouo's most toxic assets (most of which were mortgage backed securities).

Citigroup's insurance programme said that the bank itself has to cover losses on these assets up to $29bn. Above $29bn, Citigroup will have to cover 10% of any additional losses and the US government will cover the remaining 90%. This guarantee will last for 10 years.

In January 2009, a similar insurance policy was extended to Bank of America.

The UK government also announced its own insurance scheme, known as the Asset Protection Scheme in January 2009. This states that -

1) In return for an undisclosed fee, the UK Treasury will insure participating banks against future credit losses on certain groups of assets.

2) The insurance will only kick in after a 'first loss amount' (AKA 'excess' in normal insurance policy) has been exceeded. After that, the government will cover 90% of all losses on the assets specified and the bank will be required to cover the remaining 10%.

According to the Financial Times, the scheme is expected to cover around 120bn of bad loans and will last for five years.

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