Detox for Troubled Assets

From the Washington Post:

The government's plan to strip banks of troubled assets could force some firms to record large losses, but the painful purge would help restore confidence in the banking system, according to Sheila C. Bair, chairman of the Federal Deposit Insurance Corp.

Bair said yesterday that the effort might require more money than the $700 billion Congress has approved to aid the financial industry, but she added that taxpayers would probably reap an eventual profit on the asset purchases.

She said the greatest challenge was persuading banks and taxpayers to accept the necessity of the costly program.

"This takes courage to do, but if we don't do it, history shows that this kind of mechanism -- recognize the losses, get at the root of it and move on -- this is how you jump-start the economy. The other option, just to park those assets on the balance sheet, I don't think that gets us very far," Bair said in a discussion with Washington Post reporters and editors.

The government plans to partner with private investors to buy troubled assets, in part by providing financing at low cost. Bair and other federal officials said discussions were ongoing about the appropriate extent of the federal subsidy. A larger government contribution would allow investors to pay higher prices, limiting the losses that banks would record but also exposing taxpayers to greater risk.

The administration hopes to find the right balance and announce the details within the next two weeks, possibly as soon as next week, according to people familiar with the matter.

Since the early days of the crisis, plans have circulated to buy troubled assets, such as distressed mortgage loans, from banks. The Bush administration requested $700 billion from Congress to fund such a program, then instead decided to inject most of the money directly into companies. Bair said yesterday that the original plan to buy assets faltered in part because of concerns about the cost.

"What the pricing looked like, what the losses would be, I think that's what stymied this effort before," she said.

Bair, who remained in office after the election as the head of the independent FDIC, said the Obama administration appeared to understand the need for the program. She said buying troubled assets would create a clear strategy for ending the government's intervention in the banking system, something investors are eager to see.

The government's approach would involve investment partnerships with money from both private investors and the government. The government would establish multiple funds to compete with one another, creating a market that would determine prices.

Bair calls the initiative an "aggregator bank", though Treasury officials contend that the partnerships should be called "public-private investment funds."

The funds would use that capital to borrow more money, in much the way that a home buyer makes a down payment to take out a mortgage from a bank. In this case, the loan would be likely to come from the Federal Reserve. In a theoretical example, to raise $10 million, the government and the private investors might each contribute $1 million, and then borrow $8 million from the Federal Reserve. The government and private investors also could contribute different shares. Officials said the proportions remain under discussion.

The funds would use the money to buy toxic assets from banks. The private investors would manage the funds and determine how much to pay for the assets. That would allow the government to benefit from their expertise and desire to maximize profits.

The plan emerged from discussions about creating a "bad bank," in which a company's troubled assets are split off and placed in a new company, leaving behind a "good bank." Bair said the term "bad bank" was misleading because the structure of the deal should benefit both sellers and buyers.

"You end up with two healthy institutions," she said. "It's not a good bank and a bad bank; it's an aggregator bank with good upside potential because it bought at good discounts and you've got a clean balance sheet over here with an opportunity to raise private capital."

Bair emphasized that banks forced to take large losses might not need more government money because, newly cleansed, they would be in position to raise money from private investors. She said the size of the write-downs actually could be a positive, by establishing that banks are free of their problems.

"The thing that really makes people gulp about this is the size of the hole, but we view that as a strength and not a weakness," she said.

Other banks could be forced to raise money from the government. And she said it was possible that some banks would take losses too large to survive.

A key issue that has derailed past plans to buy troubled assets is the large gap between the prices banks consider fair and what investors are willing to pay.

Bair said part of that gap reflected the cost of borrowing money, because fear continues to hang over the financial markets. She said the government can eliminate that portion of the difference by providing low-cost financing.

"One of the reasons that prices are distressed right now is because of the lack of financing to make purchases," Bair said. "The government, by providing low-cost funding, it will help to tease out that liquidity premium from the pricing and hopefully get the pricing a little higher."

Even so, the losses faced by banks could be steep, raising the question of how many banks will be willing to participate. The government already has made it easier for banks to borrow money and has provided banks with fresh capital. Some banking executives have questioned why they should sell assets at a loss rather than simply hold them and wait for prices to improve.

So the plan is not to fund the banks directly, but to pay inflated prices (based on the idea that lack of financing not underlying loss value) is the problem?