White House plan to create ‘bad bank’ would increase federal influence

The Federal Reserve has cut rates to zero and flooded the financial system with money. Congress has spent $350 billion — and committed another $350 billion — to shore up the battered banking industry. Banks have already booked roughly half a trillion in losses, and analysts say they could be looking at a half a trillion more.


In his confirmation hearing last week, Treasury Secretary Tim Geithner said the White House is working on a new bank rescue plan. He was short on details, but the massive scope of the problem has prompted talk that the administration may be planning to “nationalize” a large portion of the banking industry.

In its most extreme form, nationalization would mean that the government buys (or takes) all the shares of stock and takes over operations of the company, keeping the profits. Such state ownership is typically a form of socialism; major oil producing countries, for example, have set up state-owned companies to produce and sell oil, using the proceeds to pay for government services.

Why is the government so involved?

At the heart of the problem is trillions of dollars worth of “toxic assets” owned by big banks that continue to lose value as the recession deepens. As the value of these assets has plummeted, banks have had to cover the losses with capital they might otherwise be lending to business and consumers. That pullback in lending is one of the major causes of the current recession. Until banks can clean up their books and get back on a solid financial footing, it will be hard to get credit flowing again.

What are these “toxic assets”?

In the past, most bank assets were typically direct loans to businesses or consumers. Though those loans defaulted more frequently when times got tough, bankers set aside reserves and wrote off the loans that went bad.

The wave of lending during the past decade was backed by a surge in “securitized” loans that were bundled together, placed into a trust account and then sold off. The buyers were supposed to get paid back — with interest — as the underlying loans were paid off. The bankers who created these trusts believed they had dramatically reduced the risk of default, so banks carried far less in reserve to back up these investments. In some cases, the trusts weren’t even carried on the bank’s books.

So why are they now “toxic”?

It turned out the bankers were wrong: The assets backed by loans like mortgages turned out to be much riskier than everyone thought. Some of those mortgages went to borrowers who couldn’t afford them. The computer models used to assess the risk of defaults didn’t include a recession as deep as the one we’re in. And investments backed by a mix of loans turned out to be so complicated that the bond rating agencies that originally blessed them as safe no longer vouch for them. So no one wants to buy them.

If no one wants them, then they’re worthless, right?

Not necessarily — and that question is at the center of the problem. Since they’re not being bought or sold, there’s no market price for them. But many of these investments are backed by loans that are still paying interest and principal to investors. Though mortgage defaults and foreclosures are up sharply, roughly 90 percent of people with mortgages are paying on time.

These mortgage-backed assets come with complex rules about which investors get paid first and which get hit with losses. Because you can’t know how many more mortgages will default, and some mortgages last for 30 years or more, it is extremely hard to predict what many of these assets will be worth in the future.

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