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Some Experts Say Rescue Program Might Not Work
Several Alternative Plans Proposed

By Binyamin Appelbaum
Washington Post Staff Writer
Tuesday, March 24, 2009

Investors may have cheered the administration's latest financial bailout plan yesterday, but a chorus of academics and financial experts expressed skepticism, saying there are better ways to restore the health of the banking system.

Some warned that the new plan will likely fail, or fall short, because banks will demand higher prices than investors are willing to pay.

There was also widespread agreement that the Obama administration, like its predecessor, has not done enough to explain its choice of a fraught and controversial approach.

"I think we suffer from the lack of a fuller explanation. I think they would inspire much more confidence if they explained their rationale," said Hal Scott, a Harvard Law School professor who specializes in financial systems.

Scott and others favor alternative approaches to restoring the health of the banking system.

Some experts hold that banks can be fixed by pumping more money into the capital reserves they are required to hold against future losses. Rather than removing troubled assets, banks should simply be ordered to raise more money, said Albert Kyle, a finance professor at the University of Maryland. The government would then invest in banks that can't raise the necessary money.

Kyle said that the government could pump money into banks through either asset purchases or capital injections, but only capital injections allow taxpayers to share directly in the benefits.

The Obama administration already has embarked on a version of this idea, conducting "stress tests" to determine how much additional capital banks need to weather a further deterioration of the economy. Kyle said he believes that program should be expanded, and the plan announced yesterday should be set aside.

"You have a huge transfer of wealth that's going from taxpayers to banks," Kyle said. "The right way to do that is to inject capital directly into the banks."

Most experts -- including those in the administration -- agree with Kyle that more capital injections are necessary. But they believe the government must also address the troubled assets directly. The concern is that no matter how much capital is injected into banks, investors will still lack certainty about the magnitude of eventual losses.

The government could agree to absorb banks' losses above a fixed threshold. Douglas Elliott of the Brookings Institution said such an approach could be less costly for taxpayers. It would require no upfront investment and, if the government is correct that many troubled assets will eventually recover a good part of their value, there would be few losses to absorb.

The government already has guaranteed to limit the losses on more than $300 billion of Citigroup assets and more than $100 billion of Bank of America assets. Both companies remained under tremendous pressure, but Elliott said that was because they faced other problems, in part because the guarantees were not large enough.

"Guarantees got a bad rap," Elliott said.

Other experts said guarantees also do not go far enough toward resolving the fundamental problem because the approach does not remove the bad assets completely. At the same time the government is exposed to considerable losses.

Scott is among a group of academics proposing that banks instead should be encouraged to break off a "bad bank" containing the troubled assets, with debt and equity investors awarded proportional shares in each institution.

The surviving bank would be free of its problems, and investors could realize whatever value remained in the bad bank. This approach was used successfully by Mellon Bank in the late 1980s.

The creation of bad banks would not require any direct government assistance, but Scott said it might require the opposite: a commitment from the government not to offer further aid.

"As long as the government is sort of messing around and threatening to do something else, which may be a subsidy to the banking system," Scott said, "why would they do something that's more expensive to do?"

Finally, there are critics who believe more forceful action is required. They favor an approach in which regulators would seize the most troubled institutions and put them through a cleansing process akin to bankruptcy. In this model, pursued by Sweden in the early 1990s, the government could create bad banks to hold the troubled assets, then return the purified banks to private ownership.

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