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Time for Geithner to show his cards

The long-awaited Obama administration plan to shore up the banking system is due Tuesday. Here's what the government should be doing.

By Colin Barr, senior writer
Last Updated: February 8, 2009: 1:56 PM ET

Treasury Secretary Tim Geithner is preparing to announce his comprehensive financial stability plan.

NEW YORK (Fortune) -- The Obama administration is about to face its first significant financial test.

Treasury Secretary Tim Geithner is expected to lay out the government's strategy for reviving the banking system in a speech Tuesday. The plan was originally set to be unveiled Monday, but the Treasury Department said Sunday it was postponing the announcement to allow Geithner and other economic officials to focus on trying to get the stimulus package in Congress passed first.

Since taking office last month, top Obama administration officials have promised to present a comprehensive plan to address the problems in the financial system, which has been struggling with losses on bad loans and souring mortgage-related securities.

Fixing the problems at the banks won't be simple or cheap. Economists say it will likely take more than the $350 billion remaining under the Troubled Asset Relief Program to fund the next round of federal programs.

One senior administration official told CNN the package being put together by Geithner and other top economic advisers to the President would "be an overhaul of the whole program."

Whatever shape the plan takes, it's crucial that officials reassure investors worried about the health of financial institutions and their capacity to extend credit to consumers and businesses.

Bank stocks have fallen sharply again this year, deepening a plunge that started in late 2007. Some fear that a plan the market deems insubstantial or ill-advised could lead to another leg down.

"We have to repair the banking system," said George Kaufman, an economics professor at Loyola University Chicago. "You have to do that first before you can address any other problems."

A number of options have been under discussion in Washington, notably a government-funded bad bank that would remove toxic assets from bank balance sheets as well as a taxpayer-funded insurance plan to cover losses on troubled bank investments.

Skepticism growing about bad bank idea

The bad bank idea has gotten the lion's share of the attention, with officials including Federal Deposit Insurance Corp. chief Sheila Bair speaking out in favor of a variation of the plan. Proponents say the nation's banks won't be able to lend aggressively and support economic growth until troubled assets like illiquid trading securities are removed from their balance sheets.

Recently, though, there has been some talk of a shift toward a program that focuses more on the asset guarantee approach.

Sen. Charles Schumer, D-N.Y., said earlier this week that the upfront cost of a bad bank approach -- projected by some observers to run into the trillions of dollars -- was among the factors leading legislators and administration officials to turn increasing attention to the guarantee concept. The government has already guaranteed some troubled assets held by Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500).

Whatever their merits, the bad bank and guarantee approaches share a common Achilles heel: They would commit hundreds of billions of additional taxpayer dollars at a time when Americans are wondering if aiding well-paid bank employees is the best use for their money.

Many taxpayers are up in arms about the gobs of money being made by employees of failing financial firms, despite President Obama's proposed new rules to cap compensation at banks requiring federal assistance.

Meanwhile, U.S. workers are losing their jobs at a sobering clip, and states and municipalities are cutting back on services as tax receipts plunge.

"The bad bank idea is just ridiculous," said Len Blum, a managing director at New York investment bank Westwood Capital. "The problem with these sorts of approaches is that for the government to help the institutions, it has to overpay -- which is bad for taxpayers and adds to this lack of transparency."

Having the government provide financing for private-sector purchases of troubled assets is another idea that may come into play.

This approach, in which private investors could commit funds and then borrow from the Fed or other government bodies to expand their buying power, could accomplish two important objectives. It could draw new capital into the markets, and help establish market prices for securities that have traded only infrequently and at deeply distressed prices in recent months.

One question mark hanging over this concept is how willing the banks will be to sell toxic assets at the market prices.

If the newly established market prices are below the prices at which the banks have marked the assets on their balance sheets, the banks could face more writedowns -- which could force the government to pour in even more capital.

Shouldn't some banks be allowed to fail?

Whatever the government does, there is a rising call to get taxpayers more than they got in return for the first round of TARP funding under former Treasury Secretary Henry Paulson.

"There has been a reticence on the part of the government to give out capital with appropriate restrictions," said Blum. "The problem with that approach is that it is bad for taxpayers and adds to the lack of transparency."

Estimates by the Congressional Budget Office and the Congressional Oversight Panel put the federal overpayments in the first half of TARP -- which focused on buying preferred stock from both troubled and healthy institutions -- in the range of $64 billion to $78 billion.

With questions about how taxpayer funds are being used growing, some observers say the best answer is to stop trying to prop up troubled institutions and instead resolve failing banks through the existing FDIC process - essentially letting banks fail and finding new buyers for them after the FDIC has taken them over.

The advantage to this approach, said Garett Jones, an economics professor at George Mason University in Fairfax, Va., is that it would help to spread the losses in the financial system to shareholders and bank creditors, instead of leaving the whole tab with taxpayers.

He said the government should force debt-for-equity swaps at institutions needing assistance. Existing shareholders would be wiped out and current creditors would give up some of their debt claims in exchange for ownership of the restructured firm.

In addition to being fairer, Jones said, swapping debt for equity would reduce the amount of debt weighing on the economy. That's a crucial concern at a time when the amount of domestic nonfinancial debt outstanding more than doubles gross domestic product, according to Ned Davis Research data - a ratio that's well above its long-run average.

"Why should taxpayers be bailing out firms when debtholders have plenty of skin in the game?" Jones said. "In the current bailout, what you're really doing is converting the debt of these problem banks to government debt -- and that's not what you need to do."  To top of page

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