Asset Guarantees Gain Momentum in U.S. Bank Talks

By Robert Schmidt

Feb. 4 (Bloomberg) -- The Obama administration, aiming to overhaul the $700 billion financial-rescue program, is refocusing on an effort to guarantee illiquid assets against losses without taking them off banks’ balance sheets.

Treasury Secretary Timothy Geithner is skeptical of setting up a so-called bad bank to hold the toxic securities, an option that still may form part of the final package, people familiar with the matter said. Senator Charles Schumer yesterday said debt guarantees are becoming “a favorite choice” of options because a bad bank would be too costly.

The debate comes as some former officials warn against measures that stop short of stripping banks of the illiquid investments tied to mortgages and related securities. Government protection for $400 billion of Citigroup Inc. and Bank of America Corp. assets hasn’t sparked investor confidence in the firms’ viability.

“The tough decisions need to be made,” Frederic Mishkin, a former Federal Reserve governor and research collaborator with Fed Chairman Ben S. Bernanke, said in a Bloomberg Television interview. “You have to make sure that when all is said and done, you actually have financial firms that are either healthy and the ones that are not healthy can’t stay in business.”

‘Good’ and ‘Bad’

Mishkin, a Columbia University professor, and former International Monetary Fund chief economist Simon Johnson both yesterday advocated government interventions that would split banks into “good” and “bad” units. The “good” parts should later be sold off to private investors, they said.

The administration has said it will likely announce a comprehensive plan for revising the Troubled Asset Relief Program early next week and that nothing has been settled. It is likely to use a multi-pronged approach that includes the asset wraps, some type of an aggregator bank and a mortgage foreclosure relief strategy.

With the deliberations likely to extend into the third week of Obama’s term, it is clear that settling on a program is more difficult than expected.

“The financial package, whatever they’re going to do, has to be the centerpiece” of the administration’s response to the economic crisis, said Kenneth Rogoff, a Harvard University professor who serves with Geithner and White House economics director Lawrence Summers on the Group of Thirty counselors on financial matters. “I’ve been a little disappointed that we haven’t seen it already” he said in a Jan. 30 Bloomberg Television interview from Davos, Switzerland.

‘Two Problems’

Schumer, a New York Democrat who is on the Senate Banking Committee, said there are two problems with the bad bank, also known as an aggregator bank, solution. It would probably be “very expensive,” costing as much as $4 trillion. “Second, it’s very hard to value those assets,” and the prices could be set “so low that every other bank would go bankrupt.”

While debt backstops were used to help Citigroup and Bank of America, their share prices have fallen further. Citigroup is down 8.2 percent since Nov. 23, when the Treasury announced plans to protect the bank from losses on a $306 billion pile of troubled U.S. home loans, commercial mortgages, subprime debt and corporate loans.

Bank of America has lost 36.3 percent since the Jan. 16 government agreement to guarantee a $118 billion asset pool.

Size of Guarantee

To be effective, any loss-insurance program must be large enough to encourage private investors to come back in and recapitalize banks, said Eric Hovde, president of Hovde Capital Advisors LLC, which manages $1 billion in financial-services stocks.

The government has to tell banks “we will do this wrap, but you have to go out and raise a bunch of money,” Hovde said. Still, having banks manage the assets is a better option than the aggregator bank because “you don’t get into this whole issue of how you price the assets,” Hovde said. “The government doesn’t have the infrastructure to manage them.”

As part of its overhaul of the TARP, the administration also will tighten rules on executive compensation for some recipients of taxpayer funds.

President Barack Obama reiterated in a CNN interview his concern that Wall Street executives are “still getting huge bonuses despite that fact that they’re getting taxpayer money.” He said he’ll unveil today new limits on executive compensation.

‘Close to a Meltdown’

“You’ve got a banking system that is close to a meltdown, and we’ve got to figure out how to intelligently get credit flowing again” to small businesses and consumers, Obama also told CNN’s Anderson Cooper yesterday.

The administration plans to impose a cap of $500,000 on the compensation of senior executives for firms getting “exceptional” public financing, according to an administration official. The new rules, which will apply to future bailouts and won’t be made retroactive, also force greater transparency on use of corporate jets, office renovations and holiday parties as well as golden parachutes offered when executives leave companies.

With Geithner in his second week on the job, some Republicans in Congress are looking to the new Treasury secretary to provide some clarity about the next steps.

“The seemingly ad hoc implementation of TARP has led many to wonder if uncertainty is being added to markets at precisely the time when they are desperately seeking a sense of direction,” House Republicans including Minority Leader John Boehner said in a letter yesterday to Geithner.

To contact the reporters on this story: Robert Schmidt in Washington at rschmidt5@bloomberg.net.