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Treasury Weighs Hard Choices To Save Banks
Any Path Carries Risk of Failure

By David Cho
Washington Post Staff Writer
Wednesday, January 28, 2009

President Obama's top advisers are in the final stages of debating several perilous options to right the financial system, all of which are likely to prove unpopular and in some cases carry a significant risk of failure, according to sources in contact with the officials.

The rapid deterioration of the economy has accentuated these hard choices. The health of many banks is getting worse, not better, as the downturn makes it difficult for all kinds of consumers and businesses to pay back money they borrowed from these financial firms. Conservative estimates put bank losses yet to be declared at $1 trillion.

Senior administration officials are likely to try a combination of initiatives rather than pin their hopes on a single, all-encompassing solution to help the financial system, the sources said. But their strategy may require trial and error, which could make them vulnerable to the same criticism that dogged the Bush administration's fitful management of the $700 billion rescue program.

On the table are several approaches, which officials have begun to experiment with on a smaller scale. One would give the firms a federal guarantee protecting them against losses on assets that are backed by failing mortgages and other troubled loans. Another would set up new government institutions to buy these toxic assets. A third would inject more money into financial firms in exchange for ownership stakes, perhaps ending with nationalization in all but name.

But each proposal is fraught with the risk of undermining the banking system, leaving Obama officials wrestling with how to strike the proper mix of emergency programs funded from the balance of the government's initial rescue program and any additional money requested from Congress.

Publicly, these officials said they plan to provide clearer guidelines and oversight for how government money is spent and promised to use rescue funds to help homeowners, small businesses, municipalities and other consumers as part of a comprehensive plan, which could be released this week or next. But other senior government officials and economists said they expect the bulk of the rescue funds to continue going to financial firms.

To date, the government has focused its efforts on offering federal funds to banks in exchange for ownership stakes. But the prices of bank shares are so low now that the government risks owning these firms outright if it makes a major investment of taxpayer money.

Explicit nationalization of financial companies has little support among key Obama officials, sources said. Treasury Secretary Timothy F. Geithner and top White House economic adviser Lawrence Summers think governments make poor bank managers and cannot efficiently manage a vast number of institutions, according to some of their associates.

Another danger is that by taking over a substantial portion of a bank's stock and wiping out the investment of the firm's other shareholders, the government could also precipitate a sell-off across the banking system as investors flee, fearing they could be next.

For this reason, the government may need to find a way to safeguard existing shareholders when it provides aid, though this is likely to spur anger by lawmakers and their constituents, a source said.

These risks do not eliminate nationalization as an option. The government would likely leave open the option for companies on the verge of collapse that are deemed critical to the financial system, officials said. Federal officials adopted this approach for insurance giant American International Group, which was largely taken over by the government in September. Officials are also playing a major internal role in the restructuring of Citigroup, which has received $45 billion in government aid, banking analysts said.

The proposal to set up new government institutions, or "bad banks," to buy up troubled assets harkens back to the original purpose of the $700 billion Troubled Assets Relief Program, or TARP, which was passed by Congress in October.

At the time, Treasury Secretary Henry M. Paulson Jr. said these assets were the primary reason banks were teetering and the government needed to remove them from their balance sheets. Treasury officials began consulting experts to see whether the government could use auctions to get the best price for these toxic assets. The officials quickly came to an alarming realization: Paying this market price for the assets of one bank would force all other firms to discount the stated price of the troubled assets on their books to the same level. That could blow a hole in their balance sheets, triggering losses and precipitating the collapse of companies throughout the banking system.

To prevent this scenario, the officials concluded, the government would likely have to pay an inflated price for the assets. But paying too much, while generous to banks, could damage the government's credibility with financial markets and anger politicians.

This pricing dilemma remains the most vexing question for Obama's team, which has come to believe that the problem of toxic assets must be dealt with directly, sources said. To address the massive quantity of these assets, officials are likely to combine some funds approved by Congress with additional money from the Federal Reserve in establishing new government institutions to buy up distressed assets, the sources said.

One way to potentially relieve banks from the burden of toxic assets without buying them is for the government to guarantee the value of these holdings. This approach was adopted during the bailouts of Citigroup and Bank of America over the past three months. But the cost of providing such federal insurance could be huge and would likely require an enormous commitment by the Fed -- or an additional allocation of rescue funds by Congress running in the hundreds of billions of dollars, the sources said.

Some help from the TARP bailout, government officials said, may go to jump-starting the credit markets that finance roughly half the debt owned by businesses and households. During the boom years earlier this decade, investors bought pools of mortgages and other kinds of loans packaged into securities, providing fresh funding for bank lending. But this activity ceased after traders lost confidence that the market was accurately pricing the value of these securities and assessing their risk.

The Federal Reserve is poised to launch an initiative in coming weeks to restart a segment of these markets by offering to buy highly rated commercial paper, backed by assets such as credit card debt, student loans and auto loans. Officials are considering expanding this initiative to help free up loans for municipalities, small businesses, commercial real estate and other consumer debt.

This program would be highly complex, which demonstrates another problem facing Obama's team: All of the rescue efforts are difficult to explain to ordinary Americans, who criticize the government for spending too much money to aid financial firms that started the crisis in the first place.

The bailout program "is a public relations nightmare," one government official said. He added that Obama officials are sure to face criticism for whatever course they take.

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