Sheila Bair, the FDIC’s chairman, indicated this week that banks would be given a nudge.

TO BE NOTED: From The Economist:

"America's toxic-asset plan

Dr Geithner's bank rehab

Mar 26th 2009 | NEW YORK
From The Economist print edition

There should be no shortage of buyers for American banks’ rotten assets, thanks to generous subsidies. Sellers will be harder to entice

AP

ONE way to treat a recovering drug addict is to force him to go through cold turkey. Another is to prescribe him a substitute for the original poison, such as methadone. America’s long-awaited effort to relieve banks of troubled assets leans towards the second approach, aiming to entice private buyers by offering the same supercharged leverage that coursed through the veins of the financial system during the credit boom. Paradoxically, at a time when the private sector is furiously cutting back on debt, the government sees the copious provision of cheap financing as the best way to loosen up the market for illiquid debt.

The public-private partnership announced on March 23rd marks a revival of sorts for the asset-buying component of the Troubled Asset Relief Program (TARP), a $700 billion rescue fund created last October which was quickly refashioned into a bank-recapitalisation vehicle. This time, however, the buyers will be money managers and insurers, not the government, though they will have plenty of help, through co-investment by the Treasury, cheap loans from the Federal Reserve and guarantees from the Federal Deposit Insurance Corporation (FDIC). For every private dollar invested, the taxpayer will provide a matching dollar of equity and up to $12 of other financing. Investors can walk away from their debts if a deal loses money.

In theory, private buyers, bidding against each other, should be better than the government at determining the real value of assets. But some economists have denounced the plan as a disguised subsidy posing as a market solution. The taxpayer is on the hook for most of the losses but gets only half of the profits.

Mr Geithner sees this as a price worth paying to unclog banks’ balance-sheets. And this is a cost that America has swallowed before to get out of trouble. Like the new plan, the Resolution Trust Corporation, an entity set up to resolve the savings-and-loan crisis, used auctions and government co-investment to attract buyers. Some of them made fortunes, but the mechanism helped the market to clear and was deemed a success.

This time, too, the sweet terms have piqued the interest of big fund managers, such as BlackRock and PIMCO. The biggest obstacle to their participation is no longer financial risk but the political sort, thanks to the bonus frenzy over American International Group (AIG). The Obama administration may have toned down its Wall Street-bashing, and Congress is rethinking its plan to tax bonuses at up to 90%. But many still worry that they could become a target if they reap big windfalls. Some fear that low-cost leverage might tempt buyers to overpay. Barclays Capital thinks it could lift market prices by 10-20%. The Treasury argues that these prices are artificially depressed because of illiquidity, though more pessimistic types suspect that they merely reflect future losses. Such concerns explain why, although stockmarkets leapt when the plan was announced, credit markets—generally a more reliable barometer—reacted less enthusiastically. Indices linked to risky mortgages remained near record lows.

If the plan falls flat, however, it is more likely to be because of a lack of sellers. Many banks are still holding assets, particularly whole loans, at values far above their market price because, under accrual accounting, losses can be booked over several years (see article). Even with government help, bids may not be high enough to tempt banks to deal, since any price below the carrying value would force them to take a write-down and deplete precious capital.

An example of this problem is adjustable-rate mortgages. Wells Fargo has written its portfolio (largely inherited from the acquisition of Wachovia) down to around 70 cents on the dollar. But the market price is half that. With leverage, a buyer might be prepared to pay close to its estimated “economic value” if held to maturity. But this is only perhaps 60 cents. Why sell now, and take an immediate ten-cent hit, when you can spread out the pain by holding on to the loans?

This problem is less acute in mortgage-backed securities, which holders of all stripes have been more willing to write down. Indeed, those banks, such as Goldman Sachs and Morgan Stanley, that have been most assiduous in marking to market expect to be able to sell some of their holdings for a higher price, boosting their bottom line. They may use these gains to repay TARP investments: Goldman is reportedly keen to pay back its $10 billion as early as next month.

The key to encouraging selling could be the “stress tests” being conducted on the 19 largest banks, which are due to conclude in late April. Regulators might use these to force over-optimistic banks to write loans down to levels at which they would find takers in “shotgun sales”, in the process topping them up with fresh capital in return for a bigger government stake. Sheila Bair, the FDIC’s chairman, indicated this week that banks would be given a nudge.

Still, some fear that the plan may not be big enough. Firepower of up to $1 trillion may sound a lot, but much more than that amount is in danger of souring in America as consumer credit deteriorates and more companies default. With little chance of wringing more bail-out money from Congress, barring a stunning change of mood, the new plan could hit a funding wall.

To date, just under half of the TARP’s $700 billion has been disbursed. Add in the toxic-asset plan, and the total climbs to as much as $608 billion. With large dollops needed to plug banks’ capital holes once the stress tests are completed, and other industries clamouring for help, the remaining $92 billion may fall short of what is required. One hope of topping up the pot may lie in an expansion of the FDIC’s emergency credit line, from $30 billion to as much as $500 billion, though that would require congressional approval.

So Mr Geithner faces hard choices. He will desperately want the new plan to succeed, not least because its failure could unseat him. He is already reeling from criticism that he was slow to respond to the AIG handouts. Now, at least, he has provided a detailed scheme, even if there is still devil in the details. America can claim to be tackling its troubled assets.

Whether it has picked the right approach is another matter. The alternative chosen by Britain, to leave the assets in place and insure them for a fee, has many proponents—indeed, America did just that with the worst assets of Citigroup and Bank of America, but rejected it as a system-wide solution. Others continue to push the nationalise-and-recapitalise option, though this remains politically unpalatable in America. World leaders must hope that, in banking as in narcotics, there are numerous paths to rehabilitation."