Should the Obama Administration Buy Up the Banks' Toxic Assets?

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Thursday, January 22, 2009

"THE TRAGIC history of financial crises is a history of failures by governments to act with the speed and force commensurate with the severity of the crisis," Treasury Secretary-designate Timothy F. Geithner declared at his Senate confirmation hearing yesterday. As if to illustrate the point, giant Bank of America, which had seemed solid, faltered in recent days. It took an additional $20 billion in federal help to offset the losses of Merrill Lynch, which it absorbed in a Treasury-blessed merger last fall. Bank shares generally plunged, though the markets rallied yesterday. Investors are afraid that despite many dramatic but piecemeal government interventions, big U.S. financial institutions are fundamentally unsound and face collapse or nationalization.

Against this background, Mr. Geithner said it was time for a "comprehensive" approach. "In a crisis of this magnitude, the most prudent course is the most forceful course," he said. He is right. To be sure, Mr. Geithner, though clearly able, stepped on his message by failing to pay tens of thousands of dollars in federal taxes on time. Still, his apology and explanation -- that this was an honest oversight, not an evasion -- appears acceptable to most members of the Senate Finance Committee. Barring new disclosures that clearly contradict that claim, the Senate should confirm him. We're mainly interested in what, exactly, he and President Obama plan to do.

In that regard, the latest big idea, endorsed by Federal Deposit Insurance Corp. Chairman Sheila C. Bair and others, is to set up a government-funded "bad bank," which would purchase the toxic mortgage-backed assets now clogging the balance sheets of U.S. banks. Once freed of this burden, the banks would be able to raise new capital and resume normal lending. Meanwhile, the "bad bank" would manage the assets on behalf of taxpayers, eventually reselling them as the economy rebounds. This idea has a familiar ring to it: It resembles the original plan for the $700 billion Troubled Asset Relief Program (TARP), before the money was diverted to urgent capital infusions for banks. A similar plan helped save Sweden from a real-estate-related financial meltdown in the early 1990s.

Pressed for the new administration's specific thoughts on a "bad bank," Mr. Geithner demurred. But we can think of several pitfalls. The first, simply, is cost. Sweden ended up spending 4 percent of its gross domestic product on its bank cleanup. The United States' problem today, however, is both larger and more difficult; many of the toxic assets are complex securities backed by bewilderingly sliced-and-diced debts. The second problem, closely related to the first, is how the government will set prices for the assets in the first place. Too high, and the banks make a windfall; too low, and none of them participate. This thorny issue undid the Bush administration's initial asset-buying plan for the TARP.

Sweden mitigated these problems by requiring participating banks to give the government equity, as some banks have already done under the TARP. U.S. banks might also have to accept dividend and compensation limits as well as other controls in return for definitive relief from their toxic-asset burden. If the Obama administration can answer these and other design questions -- admittedly a big "if" -- a "bad bank" could help repair the financial system. Alternatives to a "bad bank" remain under consideration. Perhaps as important as the approach chosen is the consistency with which it is carried out. Banks, investors, businesses and households need to know that Washington has a credible plan and will stick to it.


© 2009 The Washington Post Company

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