Doubts rising over plan to fix banks

Doubts are bubbling up about the current federal strategy for ending the credit crisis, even as the US government puts trillions of dollars on the line to shore up America’s shaky financial system.

At the heart of the issue is this: Is all the public money being poured into financial firms helping, or is it delaying the private sector’s unavoidable reckoning with losses?

The question is arising in hearings on Capitol Hill. It’s surfacing within the Federal Reserve itself. It is showing up in financial markets. This doesn’t mean the White House faces immediate pressure to change course, but President Obama and his economic team will navigate some difficult choices in the weeks ahead.

The options, economists say, include asking Congress for a lot more money for banks, hoping that the money committed to date will be enough to fuel an economic recovery, or reshaping policies so that bank investors shoulder burdens instead of taxpayers.

“We talk about this as if we can forestall these [bank] losses” by deploying public money, says Joseph Mason, an economist who focuses on the financial industry. “It might make sense to stop and see if we even can ... address this situation in this particular manner.”

Costs up and up

Some symbols of the rising price tag for financial rescues include the following:

•Money committed to the rescue of insurance firm AIG has climbed from an initial $85 billion last fall to $180 billion. That figure could rise further.

•Mr. Obama provided in his proposed budget for as much as $750 billion in additional financial bailout money, on top of the $700 billion that Congress has already committed. Obama has not yet formally asked for any of that added money.

•The Senate is considering a bill, backed by the administration and the Federal Reserve, that would provide a $100 billion line of credit to the Federal Deposit Insurance Corp., the agency tasked with handling failed banks. The funds would help ensure that the FDIC has adequate money at a time when more small and mid-size banks are expected to become insolvent.

Members of Congress are getting complaints from voters, who, in a recent poll, mostly disapproved of bailouts for financial firms, and in turn the lawmakers expressed frustration in hearings last week.

Fed turns critical

One implication: In this political climate, getting approval for more money to help banks won’t be easy.
Some of the criticism is coming from within the Fed itself.

“We have been slow to face up to the fundamental problems in our financial system, and reluctant to take decisive action with respect to failing institutions,” said Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, in a speech Friday. Despite trillions of dollars in public resources committed to the crisis by the central bank and the Treasury, “we have yet to restore confidence and transparency to the financial markets, leaving lenders and investors wary of making new commitments,” he said.

The credit breakdown has direct consequences for the economy.

The unemployment rate has jumped from 5 percent to 8 percent in the past year, with the breakdown in the banking system playing a big role, shaking consumer confidence and fraying business access to credit.

Agreed: Banks hold key
Financial-industry policies are just part of a larger web of economic recovery programs that the Obama administration is pursuing, in concert with the Fed. But those financial policies must succeed, Obama and his critics both say, to enable any economic rebound.

Treasury Secretary Timothy Geithner has unveiled the outlines of a “financial stability plan,” which has two elements to help banks that are being hit by a wave of loan defaults.

First, regulators are assessing the health of the largest banks, to see which banks need to raise fresh capital to weather the recession. If a bank needs capital and can’t get it from private investors, the Treasury plans to provide it.

Second, Mr. Geithner is working to set up a public-private investment fund that will buy troubled loans at marked-down prices, as a way of helping to clean up bank balance sheets.

Separately, officials including Geithner and Federal Reserve Chairman Ben Bernanke are responding to the emergencies that some big corporations find themselves in. Last week’s enlarged bailout for AIG came just days after the bank Citigroup got new assistance.

Together, these steps might prove to be effective, but they are also drawing criticism.

Two camps of economists

Finance experts generally agree that the banking system needs more capital, because loan losses eat away at banks’ existing capital reserves. But beyond that, broad differences exist.

Economists in one camp call for tougher conditions or limits on federal aid to banks. One reason is concern about the adverse impact on government finances if the rescue tab keeps climbing into trillions of dollars. Another reason is “moral hazard,” the idea that bailing out institutions sows the seeds of future crises, by embedding assumptions of government support.

“We have to think hard about what incentives we’re setting up,” says Mr. Mason of Louisiana State University.

He likens the regulator-bank relationship to that of a parent and child. If the parent always helps the child out of messes, the problems escalate.

“Each time it gets more and more costly to do so,” he says. “You have to let the market [participants] in this case feel the weight of their own losses.”

In another camp are economists who may agree that moral hazard is a concern, but who argue that discipline and new rules will come later. The first task is to make sure the financial industry remains operational.

Another dividing line between these two camps relates to estimates of the problem’s scope.

Mr. Bernanke last week rejected the word “zombie” to describe some of the largest banks. He described Citigroup, whose stock price fell to $1 per share last Friday, as “under stress,” but said it could restructure without requiring a government takeover.

Geithner, too, has emphasized that he hopes to avoid temporary nationalization of large institutions, for restructuring.

By contrast, that’s exactly what Mr. Hoenig urged in his speech. It’s a sharp debate.

Drawbacks of nationalization

In the views of Bernanke and Geithner, the nationalization of a large firm would be a slow and costly process – and one that would probably shake markets with uncertainty, as occurred when the investment bank Lehman Brothers entered bankruptcy last September.

Critics of this view say the market panics have been caused by inconsistent US policies and the resulting uncertainty.

In fact, Hoenig cited the standard used during the Great Depression as a successful model. Regulators took over insolvent institutions, restructured them, and reprivatized the operations.

Key to resolving the credit crisis is getting an accurate sense of the weakness of banks. Many economists are skeptical that the assessments now in progress, which Geithner hopes to finish by April, will settle that question. They worry that the test will not be stringent enough, that the needed capital infusions may be delayed as the Obama administration tries to hold to a minimum politically unpopular requests for rescue money.

If that’s what happens, the result could be a more protracted crisis, as investors remain uncertain about the health of big banks.

The crisis can best be resolved by making sure that banks become convincingly well capitalized as soon as possible, says Pete Kyle, a finance professor at the University of Maryland. The Geithner plan, he notes, provides for a six-month window in which banks can try to raise needed capital – too long in Mr. Kyle’s estimation.

Some capital may not need to come from taxpayers at all. By forcing holders of debt in weak banks to convert their investment into common equity – considered the strongest form of capital – capital positions could be strengthened.

How to divvy up banks’ losses?

No move comes without costs, since it’s all about different ways to divvy up big financial losses. Any shift in policy could rattle financial markets.

But already, creditors have taken a hit at some banks, and the price of large-bank debt appears to reflect the expectation that this could happen more frequently, even though this is not part of Geithner’s official plan.

At this point, even the nationalization of a large bank might not faze investors, if it were perceived as part of a clear and consistent policy.

“We think investors would ultimately respond more favorably if the US government seized [troubled] assets rather than purchased them,” Richard Bernstein, chief investment strategist at Merrill Lynch, wrote in a recent note to clients.