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Citigroup bailout doesn't calm jitters over 'toxic' assets

Rescue plan leaves troubled mortgage-backed securities on bank's balance sheet.

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Under the rescue plan, Citi will cover the first $29 billion in future losses on this pool, plus 10 percent of additional losses after that. Any remaining losses – which could add up to more than $100 billion – would fall on the Fed, the Treasury, and Federal Deposit Insurance Corp.

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"That's a lot like an insurance policy" with a $29 billion deductible and a 10 percent copayment above that, says Mark Thoma, an economist at the University of Oregon in Eugene.

"It's a way of rebuilding trust," he says. Such insurance puts somewhat of a floor under credit losses, the fear of which has rattled investors and made many banks unwilling to lend as they usually do to one another.

It's not the only way of confronting the asset problem, and it's not clear whether it's the best way.

One risk is that, at Citi and elsewhere, bad assets will simply sit on the balance sheet for years to come, impairing the health of banks. This became a problem in Japan's "lost decade" in the 1990s, distracting bankers and limiting the firms' abilities to make new loans.

Kyle also worries that the structure of the bailout may give Citi an incentive to take on new risks. Under the deal, the government provides much protection against future losses, while Citi's shareholders stand to gain most of the upside of ventures that go well.

Buying up bad assets would be complex

One alternative, which the Treasury planned to implement until recently, is for the government to buy bad assets directly.

This strategy has its own complications, mainly regarding negotiating a price for low-valued assets that is both fair and will induce banks to sell the assets. (When assets are sold at a loss, banks see a depletion of their already-scarce capital.)

But such a move would follow a time-tested approach to a banking crisis – separating the troubled assets into a "bad bank" so that good banks can then be recapitalized and benefit the economy through safe operations.

One approach might involve infusions of new capital, which are contingent on deals to sell the bad assets to the Treasury.

However the crisis is managed, it appears likely to involve significant costs to taxpayers. Still, not all bailout pledges end up in the federal budget. Infusions of capital may end up reaping a positive return when financial markets recover. Even the bad assets, if acquired by the Treasury, would earn some income or could be sold for some amount in the future.

If the Citigroup bailout becomes a template for other banks, proponents say it could provide another way to cope with bad assets. The banks could decide whether to hold or sell the assets, knowing that they have insurance against a continuing plunge in values.

Whatever solutions emerge, some experts say the key going forward is to follow a consistent pattern.

"[Policymakers] encourage really massive lobbying in Washington" by potential bailout recipients, says Edward Kane, a Boston College finance expert. "You need a plan that ... makes it clear who would and would not get help and under what terms."