Fed Wants New Effort to Cleanse Banks Hobbled by Toxic Assets

By Craig Torres

Jan. 14 (Bloomberg) -- The Federal Reserve’s top two officials urged a new effort to address the toxic assets held by financial companies, warning that they threaten to prevent banks from resuming lending to households and companies.

Chairman Ben S. Bernanke and Vice Chairman Donald Kohn said in separate remarks yesterday that the illiquid investments raise questions about the “underlying value” of banks and may hinder “private investment and new lending.” They called for the government to remove or insure the assets.

The goal is to prevent the type of economic stagnation that plagued Japan in the 1990s, when banks weighed down with bad loans were unable to lend. President-elect Barack Obama has a window of opportunity to oversee a comprehensive bank restructuring plan after taking office next week.

“Banks are insolvent now,” said Paul Miller, a bank analyst at Friedman Billings Ramsey & Co. in Arlington, Virginia, who estimates that financial institutions need an additional $1 trillion to $1.2 trillion in new help. “Until you address this shortfall, banks will continue to be credit hoarders and destroyers as they shrink their balance sheets.”

The remarks by Bernanke and Kohn came as Obama aides and legislators deliberated how to use the next half of the $700 billion financial-rescue program approved in October. Democratic House lawmakers want the Troubled Asset Relief Program deployed to help troubled homeowners, community banks and municipal-bond issuers rather than for large banks.

Lawmakers’ Priorities

House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat, said yesterday at a hearing that with “the larger banks having gotten money, we can advance to the smaller banks and community banks” in the second part of TARP.

Representative Spencer Bachus of Alabama, the panel’s top Republican, said the TARP has already “prevented a doomsday scenario” and complained that the rest of the funds are becoming a “grab bag” for special interests. The Senate plans to vote on a motion to reject the release of the next $350 billion of TARP by Jan. 18. The House also expects to vote in coming days.

Financial shares show continued concern about mounting credit losses. The Standard & Poor’s 500 Financials Index is down 12 percent this month. Citigroup Inc., which has already received a taxpayer-funded bailout, slid 17 percent two days ago and is shedding assets including its Smith Barney brokerage unit in an effort to survive.

Bank Values

“The large quantity of troubled, hard-to-value” assets “significantly increases uncertainty about the underlying value of these institutions,” Bernanke said at the London School of Economics yesterday and Kohn told Frank’s panel, using identical language.

A sustained economic recovery requires “a comprehensive plan to stabilize the financial system and restore normal flows of credit,” Bernanke said in London. He added that the Obama team’s $775 billion spending and tax-relief plan would be “unlikely” on its own to revive growth if the credit system isn’t repaired.

Consumer borrowing dropped by a record $7.9 billion in November, capping the first back-to-back monthly decline since 1992, Fed figures showed last week. Financial companies worldwide are making it tougher to get loans after recording about $1 trillion of writedowns and losses during the crisis.

Paulson, with Bernanke’s support, originally sold the concept of the TARP to Congress as an asset-purchase program. The Treasury then switched to capital injections, investing $192 billion so far. Officials said it was faster to buy stakes in firms than design a process for buying investments at a time when confidence in the industry was collapsing.

Taxpayer Risk

“They tried it once before and the Treasury backed away from it for good reason,” said Bert Ely, head of Ely & Co., a bank consulting firm in Alexandria, Virginia. “They couldn’t figure out how to price this stuff. If you pay too much, it is great for the bank, but it is bad for the taxpayer.”

Bernanke and Kohn outlined three approaches to deal with troubled assets. Public purchases are one possibility, as was originally planned under departing Treasury Secretary Henry Paulson’s design for the TARP.

The government could also agree to absorb, in exchange for warrants or a fee, part of the losses on a specified portfolio of troubled assets, he said. Regulators used that method with their November rescue of Citigroup, agreeing to backstop $306 billion of the company’s investments, while also injecting $45 billion of taxpayer capital.

‘Bad Banks’

A third solution would be to set up and capitalize “bad banks” that would purchase assets from financial institutions in exchange for cash and equity in them, Bernanke said.

One example of how a bad bank could be designed comes from Switzerland. The Swiss National bank and UBS AG in October set up a special unit to buy as much as $60 billion in toxic assets from UBS.

Zurich-based UBS provided $6 billion in capital to the fund, which will be used as first protection against losses. The SNB finances the purchase of the assets with secured loans to the fund of up to $54 billion.

“Lack of confidence in the financial system is well justified” given the “trouble they are in,” Allen Sinai, chief economist at Decision Economics in New York, said in an interview with Bloomberg Television, referring to U.S. banks.

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net