By Robert Schmidt and Craig Torres
Jan. 16 (Bloomberg) -- Renewed questions about U.S. banks' viability are pushing regulators toward a new plan that would remove toxic assets from bank balance sheets, in what may become the biggest effort yet to unfreeze lending.
President-elect Barack Obama's advisers see an increasingly grave banking crisis and are considering proposals far more sweeping than any steps that have been taken so far, according to people who've discussed the outlook with them.
“They need to do something dramatic,” said Harvard University Professor Kenneth Rogoff, a former chief economist at the International Monetary Fund, and member of the Group of Thirty counselors on financial matters, a panel that includes Treasury Secretary-designate Timothy Geithner and Lawrence Summers, incoming director of the National Economic Council.
Federal Reserve officials are focusing on the option of setting up a so-called bad bank that would acquire hundreds of billions of dollars of troubled securities now held by lenders. That may allow banks to reduce write-offs, free up capital and begin to increase lending. Paul Miller, a bank analyst at Friedman Billings Ramsey & Co. in Arlington, Virginia, estimates that financial institutions need as much as $1.2 trillion in new aid.
Other steps that may be under consideration include providing further guarantees for toxic assets that remain on the banks' books, as officials did for Citigroup Inc. in November and with a $118 billion backstop for Bank of America Corp. today, or purchasing selected investments. Federal Deposit Insurance Corp. Chairman Sheila Bair yesterday played down the alternative of nationalizing lenders.
Slump in Stocks
A move could come soon after Obama is sworn in on Jan. 20. Adding urgency to the deliberations is a deepening slide in financial shares. Citigroup yesterday sank below the level it reached when regulators mounted a rescue of the lender in November. Bank of America fell to an 18-year low as the company sought more aid from the government.
“A lot of the trouble in all this is that once you got into a financial mess, people don't know where the bodies are buried,” Paul Krugman, the Princeton University professor who won this year's Nobel Prize for economics, said in an interview with Bloomberg Radio. “People think 'Who knows what I'm getting into?'” by lending or trading with others, he said.
The Senate yesterday voted to allow the release of the remaining $350 billion from the Treasury's financial-rescue fund, giving Obama a source of funds to implement a new bank program.
The departing Bush administration used most of the first $350 billion of the Troubled Asset Relief Program for buying stakes in banks. The declines in bank shares show that the strategy has failed to shore up the banking system's solvency.
'Necessary' Initiative
A big new initiative “is going to be necessary,” said Peter Wallison, who was U.S. Treasury general counsel under President Ronald Reagan and is now a fellow at the American Enterprise Institute in Washington. “Once they have stable capital, once they feel they are not going to be run on by people who doubt the quality of their capital position, they will start lending.”
Obama's Treasury could use much of the funds to back a bigger Fed campaign to buy the illiquid assets, Wallison said. The FDIC, which has emergency 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.
In the case of Bank of America and Citigroup, U.S. officials opted to insure the illiquid assets on their balance sheets, without offloading them into any special units.
'Growing Burden'
“Troubled assets continue to mount at insured commercial banks and savings institutions, placing a growing burden on industry earnings,” John Bovenzi, the FDIC's chief operating officer, told lawmakers Jan. 13. It's “vitally important” to set up a program “capable of managing these assets until the economy and the banking industry are stabilized,” he said.
Fed Chairman Ben S. Bernanke called for “a comprehensive plan to stabilize the financial system and restore normal flows of credit,” in a Jan. 13 speech in London. He outlined options including a bad bank, “which would purchase assets from financial institutions in exchange for cash and equity.”
Bernanke was in Europe for meetings with his counterparts from the world's largest central banks to discuss the state of the global economy and financial markets. He met with U.K. Prime Minister Gordon Brown the next day.
European policy makers are also struggling to restart lending in their region, with some considering purchases of toxic assets. The U.K. and Germany this week announced new programs to guarantee loans to companies.
'Time Bombs'
“Buying toxic assets from banks is a good thing because I think confidence comes back into the banking system when you are certain -- or more certain -- that you have no time bombs ticking,” said Josef Ackermann, chairman of the Institute of International Finance, the Washington-based group that includes most of the world's large banks.
Ackermann, who is also head of Deutsche Bank AG, Germany's biggest bank, said “the real challenge here” is determining the price at which to remove the assets. He added, in a conference call with reporters Jan. 14, that Deutsche Bank doesn't need to unload illiquid assets into such a bad bank.
Switzerland in October relied on the mechanism to aid UBS AG. The Swiss National Bank and UBS set up a special unit to buy as much as $60 billion in toxic investments from UBS. Zurich-based UBS provided $6 billion in capital, which will be used as first protection against losses. It isn't clear how stockholders or bond owners would be treated in a bad-bank scenario. In the case of UBS in Switzerland, there was no direct impact on either.
Paulson Abandoned
In the U.S., the initial proposal for TARP was to buy hard- to-value assets such as subprime residential mortgage-backed securities, debt linked to commercial mortgages and collateralized debt obligations. Departing Treasury Secretary Henry Paulson abandoned it in favor of capital injections as a faster method of deploying the funds.
A more radical alternative would be the nationalization of some banks. Sweden used that option during a crisis in the 1990s. It took over two of the most troubled banks, Nordbanken AB, now part of Nordea AB, and Gota Bank, which later became a unit of Nordbanken. In addition, the government created a bad bank that bought troubled assets at a discount, while leaving financial institutions to manage their more-liquid holdings.
Bair indicated government takeovers aren't being actively considered. “I'd be very surprised if that happened,” she told reporters in New York.
The Obama economic team has been signaling plans to take bold action soon after taking office on Jan. 20 to address the problems in the banking industry.
'Act With Urgency'
“We must act with urgency to stabilize and repair the financial system,” Summers said in a letter to Senate Majority Leader Harry Reid yesterday.
Summers declined to specify how Obama will use the TARP, except for a mortgage-foreclosure prevention effort of $50 billion to $100 billion.
“How do you use this next round of money in the most efficient and effective way? This is a Rubik's Cube of a problem where there is no easy solution,” said John Douglas, a former FDIC general counsel who is now a partner at the Paul, Hastings, Janofsky & Walker law firm in Washington. “Doing something sooner rather than later to instill confidence is important.”
To contact the reporters on this story: Robert Schmidt in Washington at rschmidt5@bloomberg.net; Craig Torres in Washington at ctorres3@bloomberg.net
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