One Idea for Bank Crisis: Quarantine the Bad Assets

U.S. Officials Look To Solution Used By Sweden in '91

A housing bubble bursting, banks faltering toward failure, a nation plunging into recession.

The year was 1991, and the Swedish government responded with a dramatic plan: Unpaid loans and other troubled assets would be dumped into new state-owned banks, scrubbing the banking industry of problems in the hope of sparking a lending revival.

U.S. government officials now are considering a similar plan to address the simmering financial crisis, part of a broader discussion about ways to revamp a federal rescue effort that has helped curb panic but failed to slow bank losses or increase lending.

The idea of creating a "bad bank" to quarantine troubled assets is one of several approaches being considered, but it has gained momentum among President-elect Barack Obama's economic advisers and banking regulators. With all of the approaches, there could be hitches: Several senior officials suggested that the government is likely to need more than the roughly $320 billion remaining in the financial rescue program.

The renewed focus on toxic assets completes a trip around the block for the government's rescue efforts. In October, Federal Reserve Chairman Ben S. Bernanke and Treasury Secretary Henry M. Paulson Jr. persuaded Congress to allocate $700 billion toward a financial rescue by describing a plan in which the government would buy troubled assets from banks. Instead, they chose to focus on direct capital investments.

The investments helped some banks endure through autumn, but bank losses have continued to grow, threatening to overwhelm the government's support and preventing the banks from finding private investors. The government was forced to fashion a pair of ad-hoc bailouts for Citigroup in November and Bank of America on Friday.

"A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions' balance sheets," Bernanke said last week. "The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending."

The government could engage in direct purchases of troubled assets, but doing so would require an enormous amount of money to buy a meaningful volume. Another option under consideration is guaranteeing to limit losses on portfolios of troubled loans, as the government has done for Bank of America and Citigroup. But officials are loath to hammer out deals with one bank after another.

Creating a bad bank is viewed as the most comprehensive approach. It is also a simple, understandable solution to a complicated problem, an important consideration in confronting what is ultimately a crisis of confidence.

But a bad bank has never been tried on this scale, nor with assets as complicated as those held by U.S. banks. Bad banks are generally formed to deal with failed banks. And in almost every prior case, the cost to the government has been significant.

The idea has generated interest among key Democrats. "It's something I am very interested in, but I'd have to see the cost," said Sen. Charles Schumer (D-N.Y.), chairman of the joint economic committee.

One precedent for the discussions is the Resolution Trust Corp., created by the government in 1989 to dispose of assets from the savings and loan industry. The RTC eventually liquidated about $400 billion in assets, at an estimated cost to the government of about $125 billion. The RTC is widely viewed as successful because it helped curb the crisis.