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Bank bailout: More money, more problems

As the Obama administration moves to shore up the financial system, every possible solution raises another question.

By Colin Barr, senior writer
January 30, 2009: 3:47 AM ET

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NEW YORK (Fortune) -- The Obama administration is intent on fixing the banks. But doing so won't be simple or cheap.

Treasury Secretary Timothy Geithner has said officials are looking at a "range of options" that would boost confidence in troubled big banks. He said Wednesday that the administration expects to make its proposals public "relatively soon."

The plans are likely to include a program that would relieve banks of troubled mortgage assets, and may also feature promises for additional capital infusions or an offer to guarantee the value of some bank holdings.

Officials have been most vocal about the first option, though observers said any "comprehensive" plan, as Geithner has promised, may include elements of all three policies.

Still, while it's widely agreed that the government must do something, few expect to see the markets or the economy suddenly spring back to life once a plan is in place.

And while the administration has $350 billion in available funding under the Troubled Asset Relief Program approved by Congress last October, many observers now expect the upfront cost of the financial cleanup to run well into the trillions of dollars.

"It's not going to be a nice, clean answer," said Douglas Elliott, a fellow in economic studies at the Brookings Institution and a former investment banker at JPMorgan. "What they're looking toward is muddling through this crisis -- which sounds unsatisfying now but doesn't look too bad once you get to the other side."

Here are the pros and cons of three oft-discussed policy options.

Buying troubled assets. The creation of a "bad bank" that would take troubled assets off institutions' balance sheets could help remove uncertainty about the health of banks and give them room to resume lending.

Federal Deposit Insurance Corp. chief Sheila Bair has said officials are working on something called the "aggregator bank," which would be mutually owned by the government and the institutions that sell assets to it.

The effort is inspired by former Treasury Secretary Henry Paulson's original, unexecuted TARP proposal of last fall, and by the success of the Resolution Trust Corp., which was created by Congress in 1989 to take over thrifts that failed in the savings-and-loan crisis.

"The RTC worked, because you needed someone who could hold the assets without resorting to a fire sale," said Roger Kubarych, chief U.S. economist at UniCredit Markets & Investment Banking in New York.

Potential hurdles include the pricing of the assets to be taken by the bad bank, and the prospect of saddling taxpayers with the baggage from poor investment decisions made at privately owned institutions by well-paid executives -- many of whom remain in place.

John Koelmel, the chief executive officer of First Niagara Financial (FNFG), a community bank based in Lockport, N.Y., that got $184 million in TARP funds in October, said he was concerned about the lack of accountability for banks that lent recklessly.

"You can't perpetuate bad business practices," Koelmel said.

Making capital infusions. Paulson's original TARP proposal would have removed toxic assets, but he abandoned that plan within weeks of its passage in Congress. Instead, he plowed most of the first $350 billion of TARP funds into purchases of banks' preferred stock.

Though that effort has hardly been a success, some analysts say the Obama administration may need to repeat the TARP capital purchase program -- only with more funds, and with the government getting common stock instead of preferred shares.

Preferred shares typically pay higher dividends than common stock, and the owners of preferred stock get paid first in the event of a liquidation.

The need for a different type of capital infusion is bolstered by the sharp selloff in bank stocks this year. Despite all the Treasury purchases of bank preferred stock, investors have continued to flee the sector - in part because rising losses are eating away at banks' balance sheets.

Unless banks have a robust amount of common equity to absorb future losses, their health will remain suspect.

"You need to put in common equity," said Paul Miller, a financial services analyst at FBR Capital Markets in Arlington, Va., who has said the biggest U.S. banks need as much as $1.2 trillion in additional capital to be able to keep lending amid a sharp downturn in the economy.

One drawback to this approach is that it's costly, which could make it unpopular at a time when the U.S. is running substantial budget and trade deficits and is planning to spend hundreds of billions of dollars on fiscal stimulus.

Another is that large common-stock purchases could leave taxpayers holding big stakes in banks - though some observers suggest the government could solve that problem by instead taking warrants that convert into common stock when they're sold.

Insuring banks' assets. Another approach involves trying to put a floor on asset values by offering government insurance against future losses. The government has already made a step in this direction in recent months by guaranteeing loan losses at Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500).

Under those plans, the banks took the first loss on a pool of assets, then agreed to make a co-payment on the second round of losses. After that, all losses are to be absorbed by the government -- an arrangement that, if repeated on a broad enough scale, should reduce investors' fear that the banks will be wiped out by outsized losses on bad loans.

The plan could draw private capital back into the markets, proponents say. But skeptics say deciding what price the banks should pay for the government insurance could be difficult.

What's more, the arrangement forces taxpayers to shoulder losses from private-sector risk-taking -- while giving investors in the banks' stock and debt all the potential gains.

Because guarantees require a smaller upfront investment, "there is less downside -- but there is also less upside," said Elliott.

Those aren't the only options, of course. Some argue that the financial system won't recover until the government breaks up the biggest banks and resolves their problems through a bankruptcy proceeding of some sort.

This is probably unlikely, but it would force creditors to share in losses and wipe out some of the debts that are crippling the economy.

"Resolution is what works. Otherwise, it can be unfair to all of us -- both as taxpayers and as those who have competed on what we thought was a level playing field," said Koelmel.  To top of page


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