Obama’s bind over aid to banks

The Obama administration faces a difficult test as it prepares a plan for restoring America’s banking system to health: The cost estimates keep rising even as public mood is skeptical of anything with the word “bailout” attached.

This political bind, at a time when President Obama is stretching to win support for a large stimulus package, could affect the shape of his comprehensive plan for ailing banks.

The stakes for the economy are high. No fix for the financial system will be simple or cheap, but a plan that fails to work could prolong the recession. And some experts worry that efforts to keep costs low in the short run could end up making taxpayers foot a higher bill down the road.

“The cost of any kind of government action is going to be huge whatever way you slice it,” says Desmond Lachman, a finance expert at the conservative American Enterprise Institute in Washington. “The cost will be all the greater if they don’t do the right things.”

Already, about $350 billion has been allocated by the US Treasury to rescue financial firms.

Most Americans oppose more aid
In a Diageo/Hotline poll late last month, 56 percent of Americans said they thought Congress was making a bad move by granting authority for Mr. Obama to spend another $350 billion – the second half of that financial superfund created by Congress last fall. Fewer than one-third thought it was a good idea.

Obama, while not yet calling for additional funds, appeared to open the door to that possibility in an interview earlier this week.

“We can expect that we’re going to have to do more to shore up the financial system,” he told NBC’s “Today” show. But he rejected one rumor of the potential cost, saying, “we’re not going to be spending $4 trillion worth of taxpayer money.”

The International Monetary Fund has recently boosted its estimate of credit losses tied to mortgage loans and other US debts at $2.2 trillion, up from $1.4 trillion last fall – which represented a jump from an earlier estimate of $1 trillion.

One key reason the numbers have risen is the feedback between credit markets and the economy. A worsening economy has raised the likelihood of loans going into default. The resulting turmoil in credit markets, in turn, contributed to a sharp drop in consumer spending and business confidence – deepening the recession last fall.

The ongoing risk for the economy also creates a political risk that Obama has acknowledged.

“I do have confidence that we’re going to be able to get it right,” and restore trust in credit markets, he said in the NBC interview. But “I will be held accountable. I’ve got four years.”

New plan expected next week

Credit-market experts say Obama’s best opportunity to fix the banking system is right now, as a new president with a clean slate. Treasury Secretary Timothy Geithner has said the plan will be “comprehensive.” Details are expected next week, perhaps as soon as Monday.

The goal is to help revive healthy credit markets. In the process, lending may not increase, but the key is, “You don’t want the lending to collapse,” says Simon Johnson, an economist at the MIT Sloan School of Management in Cambridge, Mass.

He puts the likely cost for taxpayers at about $1 trillion – to cover some of the losses and to put in the new capital needed to revive the system. That number reflects the tab after accounting for gains that the government may reap by taking an equity position in banks or receiving fees from them.

But how much gets spent, and when, depends on the way any new rescue efforts are structured.

Obama's options

The options for the Obama team fall into three main categories, and according to public statements and news reports, the package is likely to be a mixture of these measures rather than an either-or approach:

•Option 1 is for regulators to nationalize. A bank judged to be insolvent would be closed, then reopened under federal control. The most troubled assets could be broken out and liquidated, while a healthy remaining bank could eventually be privatized again.

This has the advantage of simplicity, and possibly the lowest cost to taxpayers.

But opponents say the government is ill-equipped to make this Plan A, especially since it might involve nationalizing a handful of the largest US banks.

•Option 2 is to buy the troubled assets to clean up bank books. A key challenge here is how to set a price that’s fair to banks and taxpayers – and lots of money would be needed up front.

Mr. Johnson reckons that going wholly down this road might require $3 trillion to $4 trillion, although the net cost to taxpayers in the end might be close to $1 trillion.

The administration might use this approach for some assets that banks are keen to sell.

•Option 3 is to leave the bad assets where they are but create a government insurance guarantee that limits the potential losses that banks will take. This has already been done, partially, in deals with Citigroup and Bank of America.

By some accounts, this approach will play a key role for assets that, although generating some income from borrowers, would fetch very low prices if sold now.

The key for taxpayers here would be the price for such insurance, and the question is whether it would succeed in restoring confidence in the economy. Johnson says this rescue strategy is the most complicated and opaque of the three. But it would allow the government to keep initial costs down. Losses would come later.

“You’re putting up less money on the front end,” says Joshua Rosner, a banking expert at Graham Fisher in New York. But, he predicts, “The back end is going to be a lot more costly."