Obama's 'Bad-Bank' Plan Is Running Into Problems

By Albert Bozzo
|  Tuesday, Feb 3, 2009  |  Updated 3:03 PM CDT
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The Obama administration may still announce a plan next week to prop up ailing banks, but significant questions remain about key measures of the plan, as well as where the funding will come from, a source says.

Meanwhile, another source is telling CNBC that the plan for a so-called bad bank has hit a snag and may not happen at all. Working out details of bad-bank proposal is proving very difficult, this source said See video below.

Though there’s a general consensus that the federal government and the financial services industry have agreed on the need for a so-called bad bank, any announcement next week is more likely to include a group of options and general principals rather than a plan long and deep on details.

“They'll be a lot more questions unanswered than answered and they’ve got to get it right,” says an industry source.

That assessment reflects the result of discussions this week between industry leaders and the Obama administration, whose point person on the bad bank concept at this point appears to be spearheaded by Lawrence Summers, director of the National Economic Council.

The concept of a government-run entity that would buy the troubled assets of private sector firms to help clean up their balance sheets has gained considerable momentum since Federal Reserve Chairman Ben Bernanke mentioned it prominently in a major speech two weeks ago. But like an earlier auction-based plan conceived by Treasury Secretary Henry Paulson last September, it’s viability has been undermined by questions about how the assets would be valued.

Though all agree that remains a critical hurtle, it is not the only complicating factor. There’s a growing opinion that a one-size-fits all approach is not appropriate and that other measures will need to be included.

Indeed, JPMorgan Chase (NYSE: JPM) Chairman & CEO Jamie Dimon has told CNBC more than once in recent days that the bad bank concept is “one tool in the tool kit”,” adding it is a “great vehicle” for some banks.

“Some banks don't need it at all,” Dimon said, adding that Chase “probably wouldn’t sell assets to the entity. “I don’t think we need to.”

Some are pushing for more use of the combination of guarantees and insurance used by the Fed and the FDIC to “ring fence” bad assets within the institution, without technically removing them from the balance sheet.

There’s also a potential bone of contention about what kind of compensation the federal government should get for its assistance.

Thus far, it’s been preferred stock and warrants without voting rights. Now there’s growing advocacy of a common-stock approach. The issue is more complicated than it appears because it involves the government’s return (or loss) on investment as well as the issue of moral hazard issue, which could figure into how much support the plan has in Congress.

“The debate over common versus preferred is silly but it appears to be real in that it’s affecting the markets,” says  former FDIC chairman William Isaac

“We ought to be buying preferred stock,” says Rep. Brad Sherman (D.- Calif), a ranking member of the House Financial Services Committee, who voted against the TARP plan twice. “When you buy preferred stocks with warrants attached you're getting something of value. With toxic assets you don't know.”

Sherman is among those who prefer the bank recapitalization plan. “The Paulson approach minimized long-term cost to taxpayers,” he said. “The shareholder and the bank don’t want to give up a piece of the bank they want to give up a piece of toxicity.”

“My preference is preferred stock, with warrants,” says Robert Glauber of Harvard University, who oversaw the treasury’s handling of the S&L bailout, which included a bad bank concept. “So taxpayers will correctly get the upside. You want the government in and out quickly.”

Supporters of the common stock approach say it puts the government in the same situation as other shareholders.

In addition, it indirectly increases the company’s book value as well as the chance that some sort of dividend will be maintained.

“The conclusion that investors seemed to have come to is that banks have gotten the money without enough oversight and supervision and have been able to go through it without enhancing their financial condition and people are afraid that the banks will have to be nationalized at some point and essentially wipe out all the shareholder equity,” says money manager Jim Awed, managing director of Zephyr Management. “The only way to change that is to bring in another set of governance.”

“It is critical we prevent dividends from flowing to today’s shareholders until the federal government has been repaid, “ says Sherman. “If we get the same kind of stock then that may serve as an excuse to keep dividends getting paid on the common stick. “I don’t want a piece of the dividend.” 

“The debate over common versus preferred is silly but it appears to be real in that it’s affecting the markets,” says former FDIC chairman William Isaac, who also supports the recapitalization model.

The government has made it clear these banks aren't going to fail,” explains Isaac, who adds some government concerns are also unfounded because “we are way past the point we need to worry about moral hazard,”

On top of the mechanics of the rescue plan, there is also the issue of funding.

Experts say an asset purchase program of would require hundreds of billions, if not trillions of dollars.

“The overwhelming problem in this is size and scale,” says Glauber. “They need enough money to by the really toxic assets, Glauber, who has been calling for a central government entity to manage the government’s efforts for some time, is among those who estimate there are between $1.5 trillion and $2 trillion of qualifying assets.

Thus far, there has been little, if any, public debate about where the money would come from. The remaining $350 in funding from the original TARP is clearly a likely source.

“Lets use TARP round two to stick with the financial system,” Rep Paul Ryan (R.-Wisc.), the ranking Republican member of the House Budget Committee told CNBC earlier this week.

“Congress is not going to stop anything,” says Sherman. “When we voted for the TARP bill, it was guaranteed the executive branch dominated, regardless of the party, meaning would be spending the money the way they wanted to.”

House Speaker Nancy Pelosi (D-Calif.) has supported the bad bank concept publicly, as has Majority Leader Steny Hoyer (D-Md.).

However, many in Congress, including House Financial Services Chairman Barney Frank (D. Mass) have made it clear they would like to see a good chunk of the TARP funding go to homeowner relief, new lending and foreclosure prevention.

The Obama administration’s letter to Congress saying it is prepared to commit $50-$100 billion of the economic stimulus plan might satisfy that requirement.

So, if and when the Osama administration taps the TARP for the bad bank concept, the president would be better off it a show of support.

Even still, it’s generally agreed that more funding will be needed and that will require going to Congress. There’s early talk of a TARP 3. And Congress will have to be on board.

“Congress will play a far bigger role in the third $350 billion, “ says Sherman. “I would think everyone who was against releasing the second $350 million would be against the third $350 million unless it had an awful lot of provisions that haven't seen the light of day yet.”

For more stories from CNBC, go to cnbc.com.

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