'Bad Bank' Run By FDIC Possible By Next Week: Source

Talks continue between the Obama administration and financial industry representatives over a plan to further ease the credit crunch, including a so-called 'bad bank' component to buy toxic assets. If progress continues to be made an announcement is likely late next week, according to a source familiar with the discussions.

Talks are taking place again today, following a round Friday when speculation arose that a snag had been hit over the thorny issue of how to price the assets, which the banks would sell at a discounted price to the government entity.

That no longer appears to the case. The talks are said to have yielded agreement that the FDIC would run the bad bank, according to a source. That scenario has been widely speculated, especially since FDIC Chairwoman Sheila Bair has been a leading proponent of the bad bank concept. She had already essentially volunteered to have the banking supervision agency administer the program, which it did 15 year ago with a similar program meant to ease the savings and loan crisis.

"It’s not a 100 percent, but its where they are now," said the industry source, adding that Thursday could be the announcement day.

The Obama administration’s point person on the bad bank concept at this point appears to be Lawrence Summers, director of the National Economic Council.

The concept of a government-run entity that would buy the troubled assets of private sector firms to help clean up their balance sheets has gained considerable momentum since Federal Reserve Chairman Ben Bernanke mentioned it prominently in a major speech two weeks ago.

But like an earlier auction-based plan conceived by Treasury Secretary Henry Paulson last September, it’s viability has been undermined by questions about how the assets would be valued.

Though all agree that remains a critical hurtle, it is not the only complicating factor. There’s a growing opinion that a one-size-fits all approach is not appropriate and that other measures will need to be included.

Some are pushing for more use of a combination of guarantees and insurance used by the Fed and the FDIC to “ring fence” bad assets within the institution, without technically removing them from the balance sheet, such as what was recently done with Citigroup and Bank of America.

One source said that what would be unveilevd next week will likely include a "menu of options and general principles," which might address both illiquid and non-performing assets. Earlier this week, Treasury Secretary Timothy Geithner said the administration was considering a "range of options."

Indeed, JPMorgan Chase Chairman & CEO Jamie Dimon has told CNBC more than once in recent days that the bad bank concept is “one tool in the tool kit,” adding it is a “great vehicle” for some banks.

“Some banks don't need it at all,” Dimon said, adding that Chase “probably wouldn’t sell assets to the entity. “I don’t think we need to.”

Taking Stock--But How?

There’s also a potential bone of contention about what kind of compensation the federal government should get for its assistance.

Thus far, it’s been preferred stock and warrants without voting rights. Now there’s growing advocacy of a common-stock approach. The issue is more complicated than it appears because it involves the government’s return (or loss) on investment as well as the moral hazard issue, which could figure into how much support the plan has in Congress.

“We ought to be buying preferred stock,” says Rep. Brad Sherman (D.- Calif), a ranking member of the House Financial Services Committee, who voted against the TARP plan. “When you buy preferred stock with warrants attached you're getting something of value. With toxic assets you don't know.”

Sherman is among those who prefer the bank recapitalization plan. “The Paulson approach minimized long-term cost to taxpayers,” he said. “The shareholder and the bank don’t want to give up a piece of the bank they want to give up a piece of toxicity.”

“My preference is preferred stock, with warrants,” says Robert Glauber of Harvard University, who oversaw the Treasury’ Department's handling of the S&L bailout, which included a bad bank concept, known as the Resolution Trust Corp.. “So taxpayers will correctly get the upside. You want the government in and out quickly.”

Supporters of the common stock approach say it puts the government in the same situation as other shareholders.

In addition, it indirectly increases the company’s book value as well as the chance that some sort of dividend will be maintained.

“The conclusion that investors seemed to have come to is that banks have gotten the money without enough oversight and supervision and have been able to go through it without enhancing their financial condition and people are afraid that the banks will have to be nationalized at some point and essentially wipe out all the shareholder equity,” says money manager Jim Awed, managing director of Zephyr Management. “The only way to change that is to bring in another set of governance.”

“It is critical we prevent dividends from flowing to today’s shareholders until the federal government has been repaid," said Sherman. “If we get the same kind of stock then that may serve as an excuse to keep dividends getting paid on the common stock. I don’t want a piece of the dividend. I want all of it."

“The debate over common versus preferred is silly but it appears to be real in that it’s affecting the markets,” says former FDIC chairman William Isaac, who also supports the recapitalization model.

The government has made it clear these banks aren't going to fail,” explains Isaac, who adds some government concerns are also unfounded because “we are way past the point we need to worry about moral hazard.”

Where's The Money?

On top of the mechanics of the rescue plan, there is also the issue of funding.

Experts say an asset purchase program of would require hundreds of billions, if not trillions of dollars.

“The overwhelming problem in this is size and scale,” says Glauber. “They need enough money to buy the really toxic assets." Glauber, who has been calling for a central government entity to manage the government’s efforts for some time, is among those who estimate there are between $1.5 trillion and $2 trillion of qualifying assets.

Thus far, however, there has been little, if any, public debate about where the money would come from. The remaining $350 in funding from the original TARP is clearly a likely source.

“Lets use TARP round two to stick with the financial system,” Rep Paul Ryan (R.-Wisc.), the ranking Republican member of the House Budget Committee, told CNBC earlier this week.

“Congress is not going to stop anything,” says Sherman. “When we voted for the TARP bill, it was guaranteed the executive branch dominated, regardless of the party, meaning it would be spending the money the way they wanted to.”

House Speaker Nancy Pelosi (D-Calif.) has pretty much supported the bad bank concept publicly. Majority Leader Steny Hoyer (D-Md.) has also made positive comments.

However, many in Congress, including House Financial Services Chairman Barney Frank (D. Mass) have made it clear they would like to see a good chunk of the TARP funding go to homeowner relief, consumer lending and foreclosure prevention.

The Obama administration’s letter to Congress saying it is prepared to commit $50-$100 billion of the economic stimulus plan might satisfy that requirement.

So, if and when the Obama administration taps the TARP for the bad bank concept, the president would be better off if there was a show of support.

Even still, it’s generally agreed that more funding will be needed and that will probably require going to Congress. There’s early talk of a TARP 3. And Congress will have to be on board.

“Congress will play a far bigger role in the third $350 billion," says Sherman. “I would think everyone who was against releasing the second $350 billion would be against the third $350 billion unless it had an awful lot of provisions that haven't seen the light of day yet.”