Though the current administration has shut the door on using the Troubled Asset Relief Program (TARP) to buy illiquid assets from banks, policymakers are increasingly turning to the idea again as other efforts to stem the financial crisis sputter.
Top officials at the Federal Reserve Board and the Federal Deposit Insurance Corp. (FDIC)offered an outline Tuesday of how such a plan could be implemented, joining a chorus of industry representatives and other observers who argue it is the only way to stabilize the financial system.
Momentum is building for such a plan, even though the key obstacle that led Treasury Secretary Henry Paulson to spike such a proposal last year finding a way to establish prices for troubled assets remains unresolved.
Fed Chairman Ben Bernanke said Tuesday that the banking system cannot stabilize until a way is found to take illiquid assets off institutions' books.
"A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions' balance sheets," he said in a speech in London.
The Treasury could foster a market for illiquid assets in one of three ways, Bernanke said.
"Public purchases of troubled assets are one possibility," he said. "Another is to provide asset guarantees, under which the government would agree to absorb, presumably in exchange for warrants or some other form of compensation, part of the prospective losses on specified portfolios of troubled assets held by banks. Yet another approach would be to set up and capitalize so-called bad banks, which would purchase assets from financial institutions in exchange for cash and equity in the bad bank."
He was seconded by John Bovenzi, the FDIC's chief operating officer. The agency "believes the original intent of the TARP to remove problem assets from the balance sheets of banks and related entities continues to be vitally important," Bovenzi said at a House panel hearing Tuesday.
"Such a program is necessary to expand banks' balance-sheet capacity to undertake new lending, as well as to attract private-equity investment," Bovenzi said. "The development of a program to assist institutions in addressing their inventories of troubled assets should be a key component of TARP funds."
The Fed and the FDIC are essentially pushing an idea that once had vigorous support from Paulson and top members of Congress. In September, Paulson argued that the Treasury needed $700 billion to create a program that would buy up illiquid assets. He acknowledged at the time that the program faced challenges, including figuring out how to price and manage assets.
But within days of the law's Oct. 3 passage, Paulson abruptly changed course, choosing instead to focus on buying stakes in banking companies and using TARP funds for other ad hoc programs. He said he had concluded that developing a market for illiquid assets would be too tough.
Many observers say that Paulson made a mistake, and that recapitalizing banks while helpful is not enough.
"One of the big problems that we've had so far in the meltdown of the financial industry was the toxicity on the balance sheets of banks and financial institutions," said Brian Gardner, a political analyst at KBW's Keefe, Bruyette & Woods. "The original goal of Tarp was the correct one, which was to get that toxicity off of the bank balance sheets and onto the sheets of the government."
Randall Quarles, a managing partner of Carlyle Group and a former Treasury undersecretary in the Bush administration, said the capital injections were a necessary first step, though asset purchases could be helpful now.
"Given the magnitude of the capital hole, direct capital injections were the right first priority, because they create the biggest bang for the buck, while asset guarantees can be an efficient way of addressing the overall deleveraging pressure on financial institution balance sheets," he said.
It is unclear whether policymakers have found a way to price and manage assets.
"The government and the banks have a hard time coming up with a price good for both entities," said Paul Miller, an analyst at Friedman, Billings, Ramsey & Co.
Many observers say that striking a balance on prices would be next to impossible, and that the only way the program could work is for the government to be willing to overpay for troubled assets something likely to be politically unpalatable.
"The chances are that you're overpaying," said George Kaufman, a finance professor at Loyola University in Chicago. Still, "it's worth doing to get this problem behind us and getting it off the bank's hands."
Several observers said they were intrigued by Bernanke's proposal to establish a bad bank that would centralize weak assets.
"It would help get capital into healthy institutions again," Gardner said. "One of the chief public policy goals is to get capital into banks, and I think by quarantining toxic assets in bad banks, it makes it easier to recapitalize healthier banks."
But Karen Shaw Petrou, the managing director of Federal Financial Analytics, said Bernanke's suggestion to guarantee assets would be preferable.
"The guarantee authorization that was in the law was the most straightforward and operationally facile way of liquefying the market," she said.
Regardless of how the government proceeds, Lou Crandall, the chief economist at Wrightson ICAP, said the market may remain confused over the value of bank holdings.
"The mere fact you have prices on those transactions doesn't tell you very much about where prices would be in the absence of a public sector," he said. "Price discovery doesn't tell you anything if it's just artificial purchases by a government agency."
Bernanke also used his speech Tuesday to detail an "exit strategy" for returning the Fed's balance sheet to normal once the market turmoil subsides. To support nearly a dozen liquidity facilities, the balance sheet has grown 142.1% in the past year, to $2.1 trillion on Jan. 7.
"A significant shrinking of the balance sheet can be accomplished relatively quickly, as a substantial portion of the assets that the Federal Reserve holds including loans to financial institutions, currency swaps, and purchases of commercial paper are short-term in nature and can simply be allowed to run off as the various programs and facilities are scaled back or shut down," he said.
Longer-term holdings could be sold, Mr. Bernanke said, but the central bank would get rid of those assets more slowly.