Will Treasury's new bailout be better than the first one?

McClatchy NewspapersFebruary 9, 2009 

WASHINGTON — Treasury Secretary Timothy Geithner rolls out the Obama administration's bank-rescue plan on Tuesday, hoping to restore vigor to the banking sector and create a wave of new lending to reverse the nation's deep economic slump.

The plan — along with parallel economic stimulus legislation moving through Congress — together amount to a trillion-dollar-plus roll of the dice. In addition, the Federal Reserve's muscular effort to thaw frozen credit markets is the third front of a multipart federal rescue effort. All must work in tandem to arrest the nation's economic contraction.

There's little room for Geithner to err, analysts think, because October's $700 billion Wall Street rescue hasn't worked with the first half spent. And taxpayers are furious that Washington demanded so little accounting for where the initial $350 billion went.

"Given how long we have gone, I think it's very important that these particular steps are seen as a major move forward from what has already been done," said Nigel Gault, chief U.S. economist for forecaster IHS Global Insight in Lexington, Mass.

The plan is billed as a comprehensive replacement for a piecemeal effort. The new approach is designed to fix errors and restore confidence by attacking a number of problems that are tying the economy in knots.

Geithner hopes to halt the soaring rate of home foreclosures, thaw the deep freeze in credit markets, corral bad assets that are poisoning bank ledger sheets and perhaps allow more bank failures to weed out failing institutions.

Here are some answers to questions about the new Treasury plan.

Q: How will Geithner help banks?

A: The Treasury secretary is expected to announce new, limited capital injections for banks. This continues an effort started last year, where the federal government takes an ownership stake in banks in exchange for preferred stock and warrants, which put the taxpayer at the front of the line for repayment should banks fail and liquidate their assets. Most economists agree that despite the $700 billion price tag on October's unpopular Wall Street rescue, more is needed.

Q: Banks didn't boost lending to consumers after that, so why would they start now?

A: Hard to say. The Obama administration is demanding a greater accounting of how the funds will be used and a justification if lending doesn't rise. With the economy deteriorating so fast, however, loans become riskier, and banks are loath to make more bad loans — after failing for several years to be sufficiently cautious.

Q: Are these injections a back-door nationalization of banks?

A: To a degree, but the government is wary of taking controlling stakes and directing how banks lend and to whom. As part of the price for new capital injections, however, the Obama administration will restrict executive pay and impose greater disclosure of how these funds are used.

Q: Will giving the banks more capital work?

A: Most economists think it's necessary, but that doesn't necessarily mean it will work. Simon Johnson, a former research director of the International Monetary Fund, said Monday on a blog called Baseline Scenario that capital injections "will be too small and the measures will help existing management stay in place. Large banks will remain 'too big to fail' . . . Lending will remain anemic." That's hardly an endorsement.

Q: Isn't it better to let banks fail?

A: In some cases, yes — and Geithner is expected to let more fail. However, the ones whose failure could cause systemwide risks are likely to keep getting capital injections from government to avoid that danger.

In addition, the Federal Deposit Insurance Corp. will get enhanced powers to aid or shut down failing financial institutions.

Q: How would Geithner's plan help housing?

A: Obama administration officials said it would include at least $50 billion to support mortgage modifications. FDIC Chairman Sheila Bair would get a bigger role in resolving the mortgage crisis. The Bush administration ignored her call to prevent foreclosures, which rose 81 percent nationwide last year and 110 percent in California, according to RealtyTrac of Irvine, Calif.

Bair favors restructuring distressed mortgages with lower monthly payments and stretching out the loan life, guaranteeing mortgage lenders some eventual profit. Lenders have balked at taking losses up front.

Congress also is expected to follow Geithner by expanding the Hope for Homeowners effort, where lenders are encouraged to take a loss on the original mortgage in exchange for handing it over to the government. While assuming the risk of default, the government would share in any profits when a homeowner eventually sells.

Do housing experts like this?

A: Some do. Rick Sharga, a senior vice president of RealtyTrac, whose foreclosure reports are widely followed, said lenders must forgive some portion of distressed mortgages, especially for those now priced above a home's market price.

"Why aren't we seeing some more creativity from the financial institutions that were pretty creative in coming up with (now-distressed) loan products?" he asked.

Q: Wasn't the original bailout supposed to clean up bad mortgage-backed assets?

A: Yes, but the Bush administration quickly focused instead on injecting capital into banks, on the theory that it would be quicker. It didn't work.

Now, Geithner is expected to announce a new public-private mechanism that would purchase from banks distressed assets such as mortgage bonds, which few investors want. Banks wanted the government to buy these assets at inflated prices, but Geithner's plan aims for government and private investors to share the risk.

Government would create incentives for private investors to buy the assets at below face-value, and to hold them in a "bad bank." The hope is that investors would snap them up at bargain prices, gambling that they'd become profitable as credit markets return to life.

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