JOE NOCERA ESSAY


Wasn’t it just four months ago that the United States government was racing to save the American International Group, forcing the sale of weak banks and writing huge checks to stabilize the teetering banking system- The worst was over - or so we were given to believe.


It hasn’t worked out that way. In November, not long after it was handed $25 billion in new capital, Citigroup was back for more - another $20 billion in bailout money and a government backstop of more than $300 billion in potential losses. Recently, it was Bank of America’s turn. It came back because of the huge write-down of its shiny new toy, Merrill Lynch. It got another $20 billion and a backstop against losses of $118 billion in troubled assets.


When is it going to end- Because of declining asset values, the original bailout money has largely disappeared. “It’s like putting money in a pothole that keeps getting bigger,” said Daniel Alpert, the managing partner at Westwood Capital, which has offices in New York and Hong Kong. And it’s not over yet. Goldman Sachs says the world banking system has absorbed about $1 trillion in losses - but there is likely to be another $1.1 trillion yet to go. In past financial crises, it has often been the bold and brilliant stroke that has restored confidence and revived the financial system. During the German hyperinflation of the 1920s, the government actually created a new currency. During the Latin American crisis of the late 1980s, the United States government created so-called Brady bonds, which cleverly allowed banks to get their Latin American debt off their balance sheets by turning it into tradable instruments.


And here we are again, in need of bold action and strategic thinking and the restoration of confidence.


The response has got to stop being so haphazard. Think about it: Citigroup is slimming down.
Bank of America is bulking up. The government is essentially backing both approaches. It makes no sense.


I started wondering if there is a better approach. Perhaps this new idea being discussed in Washington of creating a government bank to buy up toxic assets might do the trick. It turns out I’m not the only one who’s been asking this question lately.


“I don’t want to have to do any more of these one-offs,” said Sheila C. Bair, the chairwoman of the Federal Deposit Insurance Corporation .“Nobody does.” She was referring to the Bank of America deal . But she could just as well have been talking about the Bush administration’s entire approach to the financial crisis.


Last September were the Fannie Mae and Freddie Mac takeovers, the Merrill Lynch sale to Bank of America and then the disastrous Leh man Brothers bankruptcy. After the A.I.G. rescue, Ben S. Bernanke, chairman of the Federal Reserve, and Treasury Secretary Henry M.
Paulson Jr. concluded that they needed to find a systemic approach to fixing the huge problems in the banking system. They came up with the $700 billion bailout bill.


The government was going to use funds from the Troubled Asset Relief Program to buy up bad assets from banks and other institutions . But two things had become clear. The first was that nobody had a good idea of how to value the toxic assets the government was proposing to buy. And second, the banking system had deteriorated so badly that most of that first $350 billion had to be shoveled into it as recapitalizations.


That initial recapitalization was necessary. Without it, many more banks would have been insolvent, or would have been hoarding capital, fearing future asset write-downs. But the underlying problem has never gone away. The toxic assets are still on the books. Banks still don’t really know what they are worth, so they continue to be written down in piecemeal fashion.


The key point here is that any systemic solution has to deal with the bad assets . They need to be properly valued and isolated.
The second point is that the next round of recapitalization needs to encompass the entire banking system, and needs to be enormous.


Ms. Bair, Mr. Bernanke and Treasury officials have begun talking about a new kind of bank, one that would be created and capitalized by the government, and whose sole purpose would be to buy up bad assets and warehouse them in one place.


“You would have to mark the assets at the price they were selling for,” Ms. Bair said. “I think that is an advantage.” At long last, there would be some certainty. Private capital won’t return to the banking system until that happens.


“The only rub in the ointment is back to the original problem: How do you determine the market price-” said Josh Rosner, a managing director of the research firm Graham Fisher.


Senator Charles E. Schumer also worries about the total cost.“I’m hearing $1 trillion,” he told me.“That seems low.”But, he added, “if they can adequately answer that question, the idea has a lot of appeal, both on Capitol Hill and, I think, in the financial markets.