FDIC May Run ‘Bad Bank’ in Plan to Purge Toxic Assets

By Robert Schmidt and Alison Vekshin

Jan. 28 (Bloomberg) — The Obama administration is moving closer to setting up a so-called bad bank in its effort to break the back of the credit crisis and may use the Federal Deposit Insurance Corp. to manage it, two people familiar with the matter said.

U.S. stocks gained, extending a global rally, on optimism the bad-bank plan will help shore up the economy. The Standard & Poor’s 500 Stock Index (SPX) rose 3.1 percent to 871.70 at 2:40 p.m. in New York. Bank of America Corp. (BAC), down 54 percent this year before today, rose 84 cents, or 13 percent, to $7.34. Citigroup Inc. (C), which had fallen 47 percent this year, climbed 17 percent.

FDIC Chairman Sheila Bair is pushing to run the operation, which would buy the toxic assets clogging banks’ balance sheets, one of the people said. Bair is arguing that her agency has expertise and could help finance the effort by issuing bonds guaranteed by the FDIC, a second person said. President Barack Obama’s team may announce the outlines of its financial-rescue plan as early as next week, an administration official said.

“It doesn’t make sense to give the authority to anybody else but the FDIC,” said John Douglas, a former general counsel at the agency who now is a partner in Atlanta at the law firm Paul, Hastings, Janofsky & Walker. “That’s what the FDIC does, it takes bad assets out of banks and manages and sells them.”

Bank Management

The bad-bank initiative may allow the government to rewrite some of the mortgages that underpin banks’ bad debt, in the hopes of stemming a crisis that has stripped more than 1.3 million Americans of their homes. Some lenders may be taken over by regulators and some management teams could be ousted as the government seeks to provide a shield to taxpayers.

Bank seizures are “going to happen,” Senator Bob Corker, a Tennessee Republican, said in an interview after a meeting between Obama and Republican lawmakers in Washington yesterday. “I know it. They know it. The banks know it.”

Laura Tyson, an adviser to Obama during his campaign, said banks need to be recapitalized “with different management” so they start lending again. “You find some new sophisticated management unlike the failed management of the past,” Tyson, a University of California, Berkeley, professor, said today at the World Economic Forum conference in Davos, Switzerland.

Still, nationalization of a swath of the banking industry is unlikely. House Financial Services Chairman Barney Frank said yesterday “the government should not take over all the banks.” Bair said earlier this month she would be “very surprised if that happened.”

TARP Size

Obama is under increasing pressure to drastically revamp the $700 billion Troubled Asset Relief Program for the ailing industry. While setting up a bank to buy underwater assets is emerging as a favored approach, it could drive up the cost of the rescue in excess of $1 trillion.

Frank, a Massachusetts Democrat, told reporters that he would be open to expanding the size of the bailout if the Obama administration “can demonstrate the need for it.”

Senate Banking Committee Chairman Christopher Dodd, a Connecticut Democrat, said yesterday he wants to hear more about the bad-bank idea when he meets in coming days with newly installed Treasury Secretary Timothy Geithner.

Geithner, who was sworn in Jan. 26, said today his department is considering a “range of options” for its financial-rescue plan, with the goal of preserving the private banking system. He told reporters the administration would move “relatively soon” to announce its strategy, without saying whether that would include a bad bank.

Soros’s Take

Billionaire investor George Soros said in Davos today the plan to buy toxic assets won’t be enough to get financial institutions to start lending again.

“It’s not the measure that would turn the situation around and enable the banks to lend,” Soros said in a Bloomberg Television interview. “You are nationalizing the debt and keeping the upside in private hands.”

Robert Rubin, who was Geithner’s boss as Treasury secretary in the late 1990s, warned that nationalizing the banks outright has “some serious problems.”

“You would have to find some way to insulate a nationalized financial institution from political pressure,” Rubin, who left as senior counselor to Citigroup earlier this month, said late yesterday in a panel discussion in New York. “You don’t want lending practices, I don’t think, of financial institutions subject to political pressure.”

Stimulus Package

The new administration is also pressing Congress to pass an $825 billion economic stimulus, which could complicate any effort to get additional bailout funds from lawmakers. Obama today met with chief executive officers at the White House on the stimulus.

A key question for the bad bank would be how to value the toxic assets it would buy. Geithner, in a Jan. 21 hearing before the Senate Finance Committee, outlined three possible alternatives: look at how the market is pricing similar assets; use computer model-based estimates from independent firms; and seek the judgment of bank supervisors.

“They all have limitations,” he said. “I think you need to look at a mix of those types of measures.”

Federal Reserve Chairman Ben S. Bernanke suggested on Sept. 23, when then Treasury Secretary Henry Paulson was initially considering buying bad assets, that the government should purchase them at values above the near fire-sale prices prevailing in the market.

Issuing Stock

Bair has said that cash from the TARP may help capitalize the bad bank and that commercial lenders may kick in some money of their own. One possibility that’s been discussed is issuing firms some kind of stock in the new organization as partial payment for their impaired assets.

“Along with the other agencies, we continue to provide our best thinking on potential policy decisions,” FDIC spokesman Andrew Gray said in an e-mailed statement. “I would refer you to Treasury or the White House on direction and timing.”

In any new rescue efforts, the Treasury is likely to continue to require banks to hand over ownership stakes to the government as a condition of receiving aid. Programs so far have sought preferred shares and warrants, which can be converted into common stock and cashed out on the government’s request.

Bernanke, who has endorsed the idea of a bad bank, is discussing fresh strategies for combating the financial crisis with central bank colleagues this week. The Fed today left the benchmark interest rate as low as zero, and said it’s prepared to buy longer-term Treasury securities to resuscitate lending.

Insured Assets

The Fed has participated in Treasury-led initiatives that insured toxic assets remaining on the balance sheets of Citigroup and Bank of America, and analysts said such measures could be used to complement the bad bank.

The government will likely use its ownership of toxic assets to rework soured mortgages and prevent foreclosures.

The FDIC is already modifying troubled mortgages held by IndyMac Federal Bank FSB (IMB), the successor to the failed lender managed by the agency since July. Bair, a longtime advocate of foreclosure relief, said the initiative was meant to serve as a model for the mortgage industry.

The Fed also said in a policy paper released yesterday by the House Financial Services Committee that it will ease terms on residential mortgages acquired in the rescues of Bear Stearns Cos. (BSC) and insurer American International Group Inc (AIG).

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