The Case To Buy Toxic Assets

If you ask a thousand economists how to solve the banking crises, you'll probably receive 999 different solutions.

One of the earliest endeavors announced by former Treasury Secretary Henry Paulson was buying up all the bank system's toxic assets. After several weeks pushing his $750 billion financial sector bailout, he nixed the idea deeming it a can of worms. Unraveling the paper trail of whom owned the defaulted mortgages was akin to solving a Rubik's Cube blindfolded.

The $350 billion of the first Troubled Asset Relief Program (TARP) spending proved a disaster in accountability and a failure to abate the cancer. Perhaps it is time to readdress those toxic assets.

David Ignatious, a New York Times columnist, put the problem to Eugene Ludwig, a former comptroller of the currency who has been warning about the seriousness of this crisis for nearly two years.

Ludwig said Obama's $825 billion stimulus package should be expanded to $2 trillion, change the financial rules restraining the banks from loaning and place the toxic assets in a government holding tank as it did with the bad loans during the savings and loan pratfall in the late 1980s.

Writes Ignatious:

• This detox approach seems far more sensible than nationalizing the banks. The Treasury Department's actions over the past year have amply demonstrated that government officials can make dumb mistakes just as easily as private CEOs. Treasury pushed Bank of America to buy Merrill Lynch over a rushed weekend last September without any due diligence to discover the gremlins that were hiding in Merrill's trading book. Earlier, some at Treasury believed that Citigroup could rescue the financial system as Lehman was going down. That was dumb.
  
• A look at Citi's latest financial report shows that the damage is concentrated in a few areas, even though the fear has become pervasive. The financial giant recorded a net loss of $18.7 billion for last year. The loss in North America was $24.6 billion, offset by gains elsewhere. And a chilling $19.9 billion in losses came from trading with big institutional clients; Citi lost only $3.6 billion on its consumer banking business.

• Treasury Secretary Paulson tried to stop ... giving the banks new capital through his Troubled Asset Relief Program, in the hope that the recapitalized banks would start lending again. But as the economy contracted and more loans went bad, the banks had to keep posting additional losses -- eroding their capital position by more than the government's new infusion.

• Ludwig suggests a "capital holiday" in which the current standards for "adequately capitalized" would, for the period of the downturn, satisfy the higher "well capitalized" requirements. That would help unfreeze the lending pipes.

• Another mistake is an accounting rule that forces banks to take big "mark-to-market" losses on assets they plan to hold to maturity, if those assets are judged to be "other than temporarily impaired," or OTTI in financial jargon.

Despite the incomprehensible amount of money siphoned into a sinking ship. it must be said that the S&L's government Resolute Trust Fund was successful and taxpayers recovered more than they paid.

The problem facing the financial gurus in the Obama administration is that buying preferred shares as taxpayer collateral smacks of nationalization with nothing to show for if banks continue to fail or under perform.