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Plan for Banks' Toxic Debt May Be Unveiled Next Week

The Obama administration is close to deciding on a plan to purchase bad—or non-performing and illiquid—assets from banks, according to industy sources. The plan could be announced early next week.

The so-called "bad bank" plan, would address the key problem of how to price the assets by using a model-pricing mechanism.

The model would take account of the government's ability to hold onto assets, even to maturity, and pay for the them with cheap funding. Result: the government might end up paying more than current market prices for the securities.

On the other hand, if the government paid less than the value at which the asset is carried on the bank's books, the bank would issue common equity to the government.

In previous Troubled Asset Relief Program deals, banks issued preferred equity to the federal government. But the conclusion is growing within government circles, sources say, that preferred equity is not sufficient to make the banks healthy.

Clearly, the idea of a "bad bank" is gaining momentum. On Capitol Hill today, Senate Banking Chairman Chris Dodd said he was aware the idea is under discussion and "it makes some sense to me."

The move toward a bad bank concept comes amid growing speculation that banks may need another government bailout.

Goldman Sachs economist Jan Hatzius recently said global credit losses may approach $2.1 trillion. Of that total, banks worldwide have already absorbed about $975 billion in losses, he estimated in a research report, suggesting the worst is far from over.

FBR Capital Markets analysts said eight of the largest U.S. financial institutions need up to $1.2 trillion in new common equity and that "the government is the only entity that can provide bridge capital to get past the current credit crises."

In the developing bad bank plan, it's unclear how the government would pay for assets. There has been discussion of a "certificate of net worth" in which the government gives the banks a piece of paper that essentially can be applied to capital levels. But sources could not confirm that funding mechanism for the plan or what role existing TARP money or the Fed would play in funding the so-called bad bank.

A Treasury official said nothing will be announced this week and would not comment "on specific policy decisions that have yet to be made."

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