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As Bank Crisis Deepens, Obama Has No Quick Fix

Even before they have settled into their new jobs, President Obama’s economic team faces an acute crisis in the nation’s banking system that has no easy answers and that they are not yet prepared to address.

The president’s advisers watched most banking shares fall sharply on Tuesday, reinforcing what Obama officials have known for weeks: that their most urgent financial problem is an immense new wave of losses at banks and other lending institutions that threatens to further cripple their ability to resume normal lending.

But when Timothy F. Geithner, the president’s nominee to be the Treasury secretary, appears before the Senate Finance Committee on Wednesday for his confirmation hearing, he is not expected to have a detailed plan ready.

Photo By: The Obama-Biden Transition Project

While Mr. Obama’s top advisers view the black hole in bank balance sheets as one of their most pressing problems, they cautioned that they would not be pressured into announcing a plan before they had carefully thought through all the options. Instead, they are scrutinizing an array of solutions, each of which has pitfalls and poses its own risks and dangers.

Obama officials are almost certain to intertwine help to the banks with Mr. Obama’s goal of providing up to $100 billion for reducing home foreclosures. The two goals are not necessarily in conflict. Subsidizing loan modifications so that people can keep their homes could relieve banks of the steep losses associated with foreclosures and also prevent further erosions in bank asset values by putting a floor under home prices. “Mortgages are still the underlying problem, and I really think we need to address that problem head-on,” said Christopher Mayer, vice dean at the Columbia University School of Business. “The foreclosure stuff is just trying not to have even bigger losses in mortgages than we have so far.”

Administration officials said they were determined not to repeat the mistakes of former President George W. Bush’s Treasury secretary, Henry M. Paulson Jr., who sold Congress on an elaborate strategy for shoring up banks and then shifted to an entirely different approach before he even got started.

Industry analysts said the Obama administration’s challenge would be to help banks get rid of severely devalued mortgage assets on their balance sheets — from nonperforming subprime mortgages to pools of mortgages and derivatives — without wasting taxpayer money or rewarding banks for bad practices.

If policy makers were even remotely honest, analysts said, they would force banks to take huge write-downs and insist on a high price in return for taking bailout money. For practical purposes, that could mean nationalization or partial nationalization for many banks.

One main difference between the options under consideration is how transparent the government would be about the ultimate costs to taxpayers and whether banks would be required to reveal the true magnitude of their likely losses.

The ultimate taxpayer cost could be very high. A new analysis from the Congressional Budget Office suggests that the taxpayer costs are highest when the government’s asset purchases involve opaque transactions that are difficult to understand.

When Mr. Paulson first pleaded with Congress to approve the $700 billion bailout program, known officially as the Troubled Asset Relief Program, he argued that the government might eventually recoup its entire investment because it would be able to resell its holdings when financial markets recovered.

But the Congressional Budget Office, analyzing the program’s $247 billion in bailout payments through December, estimated that taxpayers would end up absorbing $64 billion or 26 percent of that bill.

The nonpartisan Congressional agency estimated that taxpayers had already lost 53 percent of the government’s $40 billion investment in American International Group , the giant insurance company that had been insuring tens of billions of dollars in junk mortgage-backed securities against default. As part of the rescue, the government helped A.I.G. buy back billions in mortgage securities that it had insured.

As the new Obama economic team pondered a new approach, one alternative, though an unlikely one, would be to revive Mr. Paulson’s original idea of buying troubled assets through an auction process. The potential virtue of auctions is that they could get closer to establishing a true market value for the assets.

But the drawback is that many of the securities are so arcane and complex that they are unlikely to generate the volume of bidding needed to establish a real market price.

A second approach, which Mr. Paulson had already used in a second round of bailouts for Citigroup and Bank of America , is to “ring-fence” the bad assets by providing federal guarantees against losses, and separating the assets from the rest of a bank’s balance sheet.

The virtue of that approach is that it costs relatively little money up front, because the government is essentially providing insurance coverage.

The danger is that the potential cost to taxpayers of federal guarantees can be even less transparent than other approaches. As a result, the final costs to taxpayers could be huge. Indeed, the guarantees would put the government in the same business that led to immense losses from mortgage-backed securities: credit-default swaps.

In its recent report, the Congressional Budget Office estimated the $20 billion that the Treasury spent in November to guarantee $306 billion of toxic assets by Citigroup will cost taxpayers $5 billion — a 26 percent subsidy.

William Seidman, a former chairman of the Federal Deposit Insurance Corporation who was closely involved with the bailout of savings-and-loan institutions in the 1990s, said the government should simply take control of the banks it tries to rescue. “When we did things like this, we took the banks over,” Mr. Seidman. “This is a huge, undeserved gift to the present shareholders.”

One big difference between today and the 1990s is that the government back then was seizing entire failed institutions. On paper, at least, the banks in trouble today are still viable.

That leaves the third and increasingly talked-about approach — have the government buy up the toxic assets and put them into a government-financed “bad bank” or an “aggregator bank.”

The immediate virtue of the bad bank is that the remaining “good bank” would have a clean balance sheet, unburdened by the uncertainty of future losses from bad loans and securities.

Richard Berner, chief economist at Morgan Stanley, described the “bad bank” strategy as the “least bad” of available options. The main advantage, Mr. Berner said, was that the government would have to decide how much it was willing to pay for the toxic assets. In turn, that would make it easier for the public to figure out whether the government was overpaying.

Banks may not want that kind of openness, because accurately valuing the toxic assets could force many to book big losses, admit their insolvency and shut down.

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