The US government's titanic battle against the credit crisis keeps escalating – and a key reason is that despite bailout efforts, the risk of "toxic" assets lingers on.
The bailout of Citigroup last week is the latest example, but the challenge goes beyond a single giant bank.
Just a few weeks ago, Citi was among the big financial firms that received an infusion of capital from the US Treasury. The injection was designed to help them weather the current storm of sour mortgage loans, falling real estate values, and a weakening economy.
The Treasury's recapitalization program had an impact. Borrowing-cost indicators of stress retreated somewhat from panic levels seen in October.
But the new capital reserves didn't wipe away the problem that's been weighing on financial firms for 16 months: large and murky risks remaining on their books.
The best way to alleviate the credit crisis, many financial experts say, is for the positive boost of recapitalization to be matched by effective measures to address the negative drag of troubled assets.
But how to do that is a difficult question, and one that affects both the duration of the crisis and its ultimate toll on taxpayers and the economy. The Citigroup bailout offers one possible path, but not the only one.
"The American taxpayer has bought a lot of exposure to Citigroup's bad assets," says Pete Kyle, a finance professor at the University of Maryland. "As near as I can tell, Citigroup failed but the government wanted to pretend like it didn't fail."
Citi could have contributed more in bailout
Citi is so big that it couldn't really be allowed to fail, but Mr. Kyle says that in mounting a rescue the government would have been justified in seeking a larger fee for the service it provided.
In return, the government took a stake representing about 8 percent ownership of Citi, whose stock market value had sunk to about $20 billion at the time of the bailout, down more than 90 percent from its peak. Kyle says he'd prefer to see a government ownership stake of 50 percent.
Some other finance experts see benefits to treading lightly on existing shareholders during the current crisis. When government intervention wiped out shareholders at other banks this year, it fanned investor uncertainty – pushing bank stocks even further down.
In any case, the Citi rescue offers one possible model for dealing with bad assets at some other big banks. The bailout includes both new capital and a transfer of bad-asset risk to the government.
The government is compensated by getting an ownership stake and fees (dividends) on the money it puts into the bank.
The bailout focused on a pool of risky assets on Citi's books now valued at $306 billion. Analysts say these assets may end up being worth about half that amount.
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.
"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."