What if nearly half of U.S. banking assets turn out to be bad?

As the Obama administration readies a plan for the stressed financial system, it is no doubt trying to work out the potential size of the bad-asset pool.

[Bad Company]

It is no longer just subprime mortgages and exotic credit-boom securities that are considered toxic. A wide range of other assets — from certain prime mortgages to commercial real estate to plain old credit-card loans — are now experiencing soaring defaults as the economy worsens.

Indeed, Goldman Sachs Group estimates that troubled assets could exceed $5 trillion, if defined as assets that could show a loss rate close to, or above, 10%. To put that in context, $5 trillion is just over 40% of the $12.3 trillion in total assets of U.S. commercial banks.

Granted, actual losses will be much smaller than $5 trillion, and banks won’t have to sell every bad asset. Most still can reserve for a good share of their losses. Moreover, the government already is on the hook for losses at Citigroup and Bank of America, with $3.8 trillion of assets between them.

Even so, the headline number on the administration’s plan — for assets it can buy or guarantee — will have to be huge to fulfill two key aims: boosting investor confidence in the financial system and encouraging banks to lend more.

The administration has to be mindful of overcommitting, because that could damage the dollar and push up Treasury rates, along with other lending rates.

A desire to straddle these competing goals may explain the likely structure of the Obama bailout: a government-owned bad bank for really toxic assets alongside loss-sharing agreements for a larger pool of less-dangerous assets.

The bad bank allows institutions to offload the real garbage, a boon if it doesn’t trigger huge hits to capital. The loss-sharing element, meanwhile, pushes out the potential cost for government, but would have to be transparent if it were to help restore investor faith in bank balance sheets.

Loss sharing has other potential snags. It doesn’t do away with the pricing headache as even guarantees contain an implied value for an asset. If the government sets realistic values for certain assets, it risks creating prices below banks’ own marks, prompting further balance-sheet pain. If, instead, the government prices too richly, taxpayers might complain of a windfall for bankers.

Some of these challenges could be addressed by structuring help so that the government gets the upside through common stock if a bailed-out bank survives. But that could lead to effective ownership of many banks, something Treasury Secretary Timothy Geithner wants to avoid.

Spending taxpayer money never looked so hard.

The original article

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