What Happens Now to Plan to Buy Toxic Bank Debt?

Now that the focus of Treasury’s bailout plan has shifted to recapitalizing banks, there are renewed questions about what will ultimately happen with the original plan to buy troubled mortgage-backed assets.

After rejecting the idea of the government taking direct equity stakes, senior officials— including Treasury Secretary Henry Paulson and Fed chairman Ben Bernanke—are now pushing the plan as promising “more bang for the buck.”

The about-face—as well as the decision to spend at least $250 billion of the $700 billion bailout fund to buy preferred bank shares—has cast doubt about just how important the purchase of troubled assets will eventually prove to be.

That doubt is heighten by the view of experts, such as Nouriel Roubini, a finance expert at New York University, who thinks the US banks are so weakened they will need at least $500 billion in direct capital as soon as possible.

Direct capital injection is also the approach—combined with even broader guarantees—being pursued by financial authorities around the world, led by Europe.

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“What the US has done is basically play catch up, with regards to the capital injection and guarantee program,” says banking analyst Bert Ely. “I don’t think it [the asset purchase] was fundamentally flawed [but] I think it was oversold [as the only solution whereas] recapitalization is a fundamentally simpler and more straightforward process.”

Still, officials are pressing ahead with preparations for to buy or auction off the banking system’s toxic debts. On Tuesday, Bank of New York Mellon was appointed to manage the program.

Fed chairman Bernanke, speaking at the Economic Club of New York on Wednesday, insisted both parts of the rescue plan were still on track and are “highly complementary.”

AP

With some $14 trillion worth of mortgages and mortgage-back securities still outstanding, he said the aim of taking troubled assets off banks’ books was to help create liquidity and set a price that could jump-start trading in these financial instruments.

“It’s meant to be a stimulus, not a complete solution,” said Bernanke, who apparently favored direct capitalization over asset purchases long before Paulson came around to the idea, according to a report in the FT.

Direct recapitalization, particularly in the country’s nine largest banks, could take place quickly.

But even after the government sets up the auction process, it will take more time before banks would get fresh capital through assets sales because buyers and sellers have to evaluate each individual asset.

“With these assets, some might be worth selling and other might not," Ely said. "But until you have idea of what the pricing is, how can you decide?”

Helping to establish a price where none currently exists is exactly why the government’s planned auction could prove useful, argues Martin Baily, former chaiman of the Council of Economic Advisors, now at the Brookings Institution. “It will be helpful to have more clarity on the pricing of mortgage-related securities.”

But Mark Spindel, at Potomac River Capital LLC, a Washington, D.C.-based hedge fund, says the market is still waiting for clarity about the auction procedures.

There is no firm timetable yet for the roll-out of this process, according to Kevin Heine, spokesperson of Bank of New York Mellon, who deferred to Treasury whose program it still is.

Another problem is that if non-bank financial institutions become candidates for capital injections, that could further drain the $700 billion rescue package before asset auctions actually get underway.

"They have gone this far," Ely said. "I see no reason they couldn’t expand it further to other financial institutions and maybe they will.”

In the context of fast-evolving financial crisis, “I just don’t think we have seen the broadest possible parameters of this thing, Ely added. “Everything is in a high state of flux and we may see reworking of all these programs that we can not envision right now.”

Expanding candidates for direct capital injections could mean the government kitty for buying assets may soon be exhausted, raising the prospects that the program won't even get off the ground.

"It looks like this [the asset purchase part of TARP] will fall by the wayside," said Herman Moyse, chairman of the baking department at Louisana State University. "Treasury couldn't convince economists the plan was feasible."

That’s just fine for some, especially for those convinced that the banks that originated these troubled assets are the best ones to manage them.

“I think this [recapitalization] plan is far superior to the asset acquisition plan which I never believed made any sense at all,” said Richard Bove, a banking industry analyst with Landenburg Thalmann told CNBC last week.

A Congressional source, working on a finance committee, said it was politically difficult to admit mistakes and suggested that if there are no auctions by January 20, when a new administration takes over, the program may that much more easily dropped.

© 2008 CNBC.com