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One Idea for Bank Crisis: Quarantine the Bad Assets
U.S. Officials Look To Solution Used By Sweden in '91

By Binyamin Appelbaum and David Cho
Washington Post Staff Writers
Sunday, January 18, 2009

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.

But it was in the business of liquidating failed banks. A new aggregator bank would have the very different mission of trying to keep banks alive.

Even if it pursues the idea of a bad bank, the Obama administration is likely to pursue other strategies, too. It has committed to investing as much as $100 billion in a program to limit foreclosures by restructuring mortgage loans, something most experts view as critical to stabilizing housing prices. The government also is embarking on efforts, mostly through the Fed, to make mortgage loans cheaper and easier to get. That would benefit banks by limiting losses and increasing demand for loans.

At the same time, experts agree that many banks will need additional capital before they can expand lending. Obama's advisers are considering a program that would require banks to match government investments with money from private investors.

For years, banks funded mortgages by packaging them into securities and selling them to investors. But when the debt bubble burst, investors stopped buying these assets because their values were tied to falling home prices.

As a result, banks had to continually mark down the assets' value. Investors who normally would have lent money to these institutions closed their wallets, fearing their money would vanish in the next round of markdowns.

Perhaps the key question for the Obama administration is how to buy these troubled assets, and how much to pay. The government cannot reasonably buy all the troubled assets in the marketplace. Instead, officials hope to restore a market for them by setting a minimum value -- the price that the government is willing to pay.

The difficulty is that banks think their assets are worth more than investors are willing to pay. If the government sides with investors, the banks will be forced to swallow the difference as a loss. If the government pays what the banks regard as a fair price, however, the markets may ignore the transactions as a bailout by another name.

Most economists favor an approach in which the government would pay market prices, and then help the banks cover the losses through a program of capital injections.

A second issue is the financial relationship between the government bank and the private banks. Bernanke described a model in which the banks would transfer their assets to the government for a combination of cash and equity in the new national bank, limiting the cost to the government.

Some financial experts, however, say investors won't be happy if the banks still have lingering ties to the bad assets.

"You really want to free the banks completely of all this toxic stuff, put it behind them and make sure they have no exposure. We're trying to resolve uncertainty here," said Simon Johnson, a professor at the Massachusetts Institute of Technology and a former chief economist at the International Monetary Fund who has advocated for months that the government create a bad bank.

At the same time, Johnson and other are increasingly critical of the government for failing to demand substantial equity stakes in the banks that it rescues, limiting the benefit to taxpayers as the private companies recover. As part of any bad bank program, they say, the government should require banks that participate to surrender to it a considerable ownership stake.

In Sweden, which experienced its own real estate bubble, help came at a heavy price. Banks had to sell the assets at a loss and surrender stock to the government. Bondholders were protected, but shareholders lost all of their money.

The government, meanwhile, was forced to nationalize two of the largest banks. It then split each of those banks into two pieces, creating a pair of bad banks to hold troubled loans. The remnant "good" banks were then merged into a single company, which was privatized.

In all, Sweden spent about $4.5 billion on the bailout and eventually recovered about $1.7 billion from asset sales, or about 38 percent of the original cost, according to a 2007 paper by O. Emre Ergungor, an economist at the Federal Reserve Bank of Cleveland.

Several U.S. economists have urged the government since last fall to consider the Sweden approach. They also find support in the example of Japan, where regulators allowed banks to struggle under piles of bad debt for years, which curtailed new lending and allowed the economy to stagnate.

The government eventually moved to clean up troubled assets, but the intervention came only after a recession that lasted through most of the 1990s, a period now commonly referred to as "the lost decade."

Staff writer Heather Landy contributed to this report.

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