Obama Bank Rescue May Make New Effort to Resolve Toxic Assets

By Robert Schmidt and Rich Miller

Jan. 18 (Bloomberg) -- President-elect Barack Obama is likely to back a financial-rescue effort that channels capital to banks and deals with troubled assets clogging balance sheets, according to people familiar with the matter.

Obama’s team will also use part of the $350 billion remaining from the Troubled Asset Relief Program to help stem foreclosures and assist municipalities that are having trouble borrowing, the people said. The Federal Reserve and Federal Deposit Insurance Corp. are advocating a government-backed “bad” or “aggregator” bank to acquire hundreds of billions of dollars of troubled securities now held by lenders.

Last week’s sell-off in financial stocks and the deepening recession put pressure on Treasury Secretary-designate Timothy Geithner and Obama’s economics chief Lawrence Summers to unveil a comprehensive program soon after Obama is sworn in on Jan. 20. Without a radical new effort, soaring credit losses could prolong and deepen a recession that is now more than a year old.

“We have a deteriorating real economy and deteriorating financial sector feeding on each other,” said Raghuram Rajan, a former chief economist for the International Monetary Fund who’s now a professor of finance at the University of Chicago. “It may be distasteful but we need to put more money in the banks.”

An Obama adviser, who declined to be identified, said the incoming administration has yet to settle on a plan for using the TARP money to aid financial institutions.

Praise From Bair

Outgoing Treasury Secretary Henry Paulson and FDIC Chairman Sheila Bair, who will likely remain at her post, praised the so- called bad bank idea on Jan. 16, backing up comments earlier in the week by Fed Chairman Ben S. Bernanke and Vice Chairman Donald Kohn.

“A lot of work has been done on an aggregator bank” and other ways of using the $700 billion financial-rescue fund to “go further when it comes to dealing with illiquid assets,” Paulson told reporters in Washington.

An alternative would be to provide guarantees for the assets while they remain on the banks’ books. The Treasury, Fed and FDIC took that approach on Jan. 16 when they provided a backstop of $118 billion for Bank of America Corp. The company also received a $20 billion capital infusion.

“Moving these problem assets off banks’ balance sheets may open the market to new capital, both to purchase the troubled assets and to recapitalize the banks,” said Brian Olasov, a managing director at the McKenna Long & Aldridge law firm in Atlanta. “Credit won’t flow in material ways until bank portfolios are cleansed and collateral values are re- established.”

Toll on Economy

The U.S. economy showed further signs of buckling under the weight of the credit crisis, according to reports last week. Consumer prices fell 0.7 percent in December, capping the smallest annual increase since 1954, the Labor Department said. Industrial output shrank 2 percent, and the capacity-utilization rate slid to 73.6 percent, according to the Fed. A private survey showed consumer sentiment little changed in January.

Obama is set to take office on Jan. 20 and his advisers have been working to craft a comprehensive blueprint for overhauling the bailout. Summers, speaking to business executives on a recent conference call, said that the new administration wanted to have its financial recovery plan work in tandem with the $825 billion economic stimulus it proposed.

Summers, according to one person on the call, said Obama would have a significantly different approach to implementing the TARP.

New Approach

Paulson and Bernanke sought to end a series of ad-hoc interventions with financial companies last September, by urging lawmakers to approve the TARP legislation. While the initial proposal was to use the rescue funds to purchase illiquid assets, Paulson instead bought stakes in banks.

The Obama administration’s “principle advantage over Secretary Paulson is that they are not acting on an ad-hoc basis,” said William Sweet, a partner at the Skadden, Arps, Slate, Meagher & Flom law firm in Washington who represents financial institutions.

The Senate Jan. 15 approved the release of the second half of TARP.

A Bernanke-led oversight panel issued a report last week calling for Treasury to “continue to take actions under the TARP to stabilize financial markets, help strengthen financial institutions, improve the functioning of credit markets and address systemic risks, given the disproportionate consequences that instability of the nation’s financial institutions and markets may have for the broader economy.”

Price Tag

While Summers told Congress Obama’s Treasury would use between $50 billion and $100 billion for a mortgage modification program, a good chunk of the rest of the funds could be used to buy the illiquid assets from banks. The FDIC, which has authority to take “any action” with insured deposit-taking firms deemed necessary to counter “adverse effects on economic conditions or financial stability,” could also play a role.

“We think by leveraging TARP funds in this way, you could have a significant capacity to acquire troubled assets,” Bair said. Officials could “require those institutions selling assets into this facility to contribute some capital cushion themselves.” Bair spoke in an interview with CNBC.

To contact the reporter on this story: Robert Schmidt in Washington at rschmidt5@bloomberg.net; Rich Miller in Washington rmiller28@bloomberg.net