After months of delay, the Treasury Department detailed a plan Monday to clear out as much as $1 trillion in so-called toxic assets from the financial sector in an effort to strengthen the banks enough to get them to lend again.
The public-private plan would have private investors and the Treasury put in equal amounts of money that would then be backed by a loan guarantee from the Federal Deposit Insurance Corp. to buy loans and mortgage-backed securities from the banks.
Both the taxpayers and the private investors would gain from any profits if the assets eventually gain value. The taxpayer would take most of the downside risk.
The plan is considered the linchpin of the government's strategy to get the financial system working again to provide the credit the economy needs. Since the credit crunch intensified in September, millions of jobs have been lost and the economy has contracted at the fastest pace in decades. The fallout from the U.S. banking crisis has spread around the globe.
The assets are considered "toxic" because the market for them has dried up as home prices have plunged. Banks are unwilling to sell the loans and securities for pennies on the dollar, and investors are cautious about overpaying for assets that might become worthless. In the meantime, the banks have reduced their lending because their required capital is worth less than they thought.
The Treasury plan is an attempt to give both the banks and potential buyers an incentive to make a deal. The reaction was highly favorable on Monday. Stocks jumped on Wall Street on optimism that the plan would work. Banks stocks in particular gained.
The plan offers "the best prospect for a financial recovery," said Lawrence Summers, top economic adviser to President Barack Obama.
"The goal of this program is to restart the market for legacy securities, allowing banks and other financial institutions to free up capital and stimulate the extension of new credit," the Treasury said in a news release. The plan was designed "to make the most of taxpayer resources."
Geithner said private investors could take losses if the assets fall in price. He said an auction would determine the price paid for the assets.
"Unfortunately, we will not know until we see the program in actual operation," said Douglas Elliott, an expert on the bank crisis at the Brookings Institution, a middle-of-the-road think tank. "There are substantial reasons to be concerned that the program will fizzle or prove to be too expensive for the taxpayer, but there are also some grounds for hope."
One key stumbling block is that the assets could already have lost 70% of their value, Elliot said. Jeremy Siegel, a professor at the Wharton School of Business, said the plan would prove attractive to private investors because it was like a "call-option" on the toxic assets.
"If the asset values go below the purchase price, the Treasury is going to eat that loss. This plan is definitely going to work," Siegel said in a television interview.
The Treasury's ambitious program would revolve around five steps:
- A bank decides what pool of assets they would like to sell.
- After determining that it would be willing to leverage the pool, the FDIC will conduct an auction. For instance, mortgages with $100 face value would be bought for $84.
Of the $84, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity. - The Treasury would then provide 50% of the equity financing. In this example, Treasury would invest $6 and the private investor would contribute the other $6.
- The private investor would manage the servicing of the asset pool using managers approved by the FDIC.
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