Should US take over weak banks?

The Obama administration is trying to pull off the bank-policy equivalent of a high-wire act: It hopes to intervene at troubled banks forcefully enough to avoid a multiyear recession but not so forcefully as to take control of large banks.

Judging by the history of other financial crises, it’s a hard act to pull off – especially when officials want to keep a lid on the amount of taxpayer money spent on the rescue.

That explains why lawmakers in Congress and Wall Street investors are so eager to see more details from Treasury Secretary Timothy Geithner, who unveiled the outlines of a bank-rescue plan last week.

With the world economy mired in recession, and with troubled banks a key obstacle to recovery, the matter of how to fix the financial system was a key question over the weekend at a summit in Rome of seven developed nations’ finance ministers.

How tough to be on banks is at the heart of the debate. Nationalizing weak banks, even large ones, is the surest way to end the credit crisis, say many finance experts. But that course carries large risks for the economy, say others, arguing that the Obama team is right to seek an alternative fix.

“We’ve dug ourselves a deep hole here,” says Douglas Elliott, a finance expert at the Brookings Institution in Washington. “There are no good solutions.”

He sees big costs and risks if the government takes over large troubled banks. But if bank losses keep rising, he says, that may become the best way out.

The battle over how to fix the banking system has been getting sharper in recent weeks, because of grim economic data and anticipation of the Obama administration’s plan.

Secretary Geithner laid out a two-pronged approach to dealing with America’s commercial banks. First, the US Treasury plans to set up a public-private fund to buy soured loans from banks. If it succeeds, it would remove many of the assets that have raised doubts about the banks’ health.

Second, the largest banks will face a new US-administered “stress test,” looking at how well they could survive over the next couple of years in an adverse economy.

Those needing more capital will get an infusion from the government. In return, the Treasury will get preferred shares in the banks, which would be convertible after seven years into common stock, Mr. Elliott says.

By taking preferred stock initially rather than common stock, the government delays the question of nationalization. If a bank’s share price recovers, the Treasury might never end up with a majority stake.

This course of action is driven by Geithner’s conviction that the government should avoid nationalizing big banks, if possible. Bureaucrats and politicians have no track record running America’s biggest banks, and he doesn’t want to run an experiment on that during a crisis.

Many financial experts agree.

“I do not think it would be taken very well by the markets,” says Jim Sarni, a managing principal at Payden & Rygel, a mutual fund company in Los Angeles. “Having a major bank go down would not be good.”

1 | 2

Next