The government bailout of Citigroup may have resolved that bank's problem with toxic mortgage debt. But the rest of the banking industry is still struggling with an estimated $2 trillion of such debt.
As part of the Citigroup rescue, the government agreed to shoulder most of the potential losses from $306 billion in risky mortgage assetsand inject another $20 billion in capital into the bank, the biggest effort yet to prevent a big bank from failing.
But the move was “highly customized” to Citigroup and probably does not offer a template for other banks, says industry analyst Bert Ely.
In part, that's because the other major banks may be in better shape financially.
"I don't see anybody else in the same situation, but that could change tomorrrow," Ely says.
The government also may be reluctant to guarantee all the toxic debt held by the nation's banks, which could result in huge losses for taxpayers.
But the government isn't about to start buying the assets either—which was the original purpose of the $700 Wall Street bailout fund, known as Troubled Asset Relief Program, or TARP. Treasury Secretary Hank Paulson recently abandoned that strategy, which many analysts think was a bad idea to begin with.
See video for a debate on the merits of the Citi bailout.
“The fact that the Citi deal is structured this way is further affirmation that the notion of buying out troubled assets didn’t make sense," Ely says. "They have not yet figured out how to make it work and I don’t think they ever will.”
So what are banks supposed to do with all those bad assets? The question is especially important now because as housing prices continue to drop, that debt is becoming more toxic—not less.
The Treasury’s attitude seems to be to “let the banks deal with this," says Nariman Behravesh, chief economist with IHS Global Insight, a forecasting and advisory firm. "But banks seem singularly unwilling to take any kind of big risk, understandably. They are very gun-shy after having been burned badly.”
Many banks are reluctant to unload these assets right now at severely depressed prices, says Ely, especially because the government's capital injections have made the banks' balance sheets stronger.
“The capital injection helped in the sense that it gives you the room, the balance sheet room, to write assets down and still be adequately or well capitalized,” Ely says.
The problem is that the continued housing slump makes these assets “more toxic, not less,” says Christopher Probyn, chief economist with State Street Global Financial Advisors.
"It begs the question: can you solve the problem while the [mortgage-backed] assets are still out there on the balance sheets of these institutions?" Probyn says. "Or do you need to warehouse them, somehow to get them off the balance sheets?”
The longer the housing and banking crisis continues, he adds, the deeper and more prolonged the recession will be. That places “additional strains on financial markets to the point where something else might break," he says. "The markets have still not recovered from Lehman.”
“We are as close to a Lehman-type situation as we have been,” says Edward Harrison, an economic consultant and former fixed income trader, who is worried by widening corporate bond spreads.
“The high yield market for me is the canary-in-the-coal-mine, the corporate bonds are getting killed and that’s suggestive of some problems and some one is going to get hurt.”
Brian Bethune, chief financial economist for IHS Global Insight, says the Citi deal exposes taxpayers’ to potential losses of more than $105 billion in the worst-case scenario.
That’s on top of the $45 billion of TARP money the government has already invested in the bank which he said could have been bought for about $25 billion at the end of last week.