Speculation grew on Friday that the Obama administration could announce fresh plans to clean up US banks within days of taking office next week, after a top regulator called for a new bank to be set up to unblock the system.
Sheila Bair, the head of the Federal Deposit Insurance Corporation, called for the creation of an “aggregator bank” to buy toxic assets now hampering bank balance sheets and making it difficult for them to raise capital or expand lending.
Outgoing Treasury secretary Hank Paulson offered support for such a move, telling reporters “a lot of work has been done on an aggregator bank” and other ways of “dealing with illiquid assets”.
Since the start of the credit crisis, banks have been sitting on billions of dollars of unwanted assets for which there are few buyers and only firesale prices.
Mr Paulson originally proposed using the $700bn Troubled Asset Relief Programme (Tarp) to buy some of these assets but ended up using the first $350bn for bank recapitalisation instead.
Ms Bair, who is to stay on under the Obama administration, told CNBC that the government could set up a fund to buy toxic assets that would be capitalised with equity from the second $350bn tranche of Tarp money and geared up with loans.
“By leveraging funds in this way we could have significant capacity to acquire troubled assets,” she said.
Her comments follow Friday’s announcement of Bank of America’s rescue.
While the Obama team has kept its own thinking under wraps, bank regulators and Federal Reserve officials consulted by the incoming administration have made it clear they think a further push to deal with toxic assets is essential.
Fed chairman Ben Bernanke called this week for a fresh effort to clean up the banking system, saying the continued presence of toxic assets on bank balance sheets “significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending”.
One possibility is that the Obama team might expand the model used in both the BofA rescue and the November Citigroup bail-out – insuring a ring-fenced pool of toxic assets.
But there is strong backing for the “aggregator bank” approach mentioned by Ms Bair, which many experts believe offers a cleaner break by taking the bad assets off the bank’s balance sheet entirely.
Fed officials think such a vehicle could be modelled on the Term Asset-backed Securities Loan Facility – a Treasury-Fed joint venture in which Treasury provides equity risk capital and the Fed provides leverage.
The Fed could only provide short-term funding to an aggregator bank, because of concerns about the maturity profile of its balance sheet. But a government-backed “aggregator bank” could issue its own longer-term debt, possibly with explicit guarantees from the FDIC or the Treasury.
This week, banks ran into yet deeper crisis: the sector is in more trouble than was feared. As Ben Bernanke, chairman of the US Federal Reserve, noted in a speech in London this week, however, economic recovery will not begin until the financial sector recovers its health. Governments must act.
In October, following a British lead, governments around the world recapitalised their banks. This drastic measure saved the sector from collapse. But, as the events of this week have demonstrated, the banks are still on the ropes.
Bank of America required $20bn of capital and guarantees from the US taxpayer and Anglo Irish Bank was nationalised to halt a run by depositors. Deutsche Bank, meanwhile, revealed striking fourth-quarter losses. Banks are not lending, but are hoarding capital in readiness to absorb losses from existing bad loans and securities.
Governments must now act swiftly to move ahead of the crisis. Ad hoc nationalisation of insolvent banks and recapitalisation of impaired ones is simply not enough. Governments must act to draw out the poisonous uncertainty caused by the toxic assets held by solvent banks.
The first option is to create a “bad bank”: in this model, the state would buy up toxic securities from a range of banks and hold them. This would force participating banks to declare large losses, but by removing these illiquid assets from the balance sheet, create certainty about their solvency. It would be a difficult policy to run: it would involve pricing assets that have proved unpriceable and require enormous, up-front costs. The US Treasury’s $700bn troubled asset relief programme was originally intended as a bad bank programme, but changed focus for these reasons.
A better solution, albeit one that must be worked out bank-by-bank, is the insurance model used at Citigroup and, this week, at Bank of America. Governments can, for a fee, issue insurance on the value of a bank’s unpriceable assets, making up the difference if they fall below an agreed floor price. Investors would know that the bank is secure – as with the bad bank model – but it reduces the need for already stretched finance ministries to find money immediately. Simply writing the insurance makes it less likely it will even be needed.
Even after that, however, governments may need to do yet more. They may guarantee credit yet further, perhaps even lending directly, in sectors where commercial lenders have all pulled out. Countries that used to rely on credit from abroad that has now disappeared, as is the case in the UK, may still be stretched even if their domestic banks extend themselves fully. Fixing the banks will not cause a return to growth: we are now caught in the jaws of a global recession. It is, however, a necessary precondition for recovery.