- The Washington Times - Sunday, March 22, 2009

The government is preparing to announce early this week its plan for helping major banks get rid of up to $1 trillion in toxic mortgage assets, but the burgeoning scandal over bonuses at American International Group already has cast a big cloud over the long-awaited plan.

Federal Reserve Chairman Ben S. Bernanke and other economists have called the toxic-loan cleanup plan critical for restoring health to the banking system and pulling the economy out of a deep recession. It will rely on a variety of “public-private partnerships” to dispose of currently unmovable subprime and exotic mortgage securities on the books of big banks such as Citigroup and Bank of America.

While past bank cleanup programs have taken the traditional route of the government taking over the banks, closing them and disposing of their bad loan assets through a costly process akin to a bankruptcy proceeding, the plan crafted by Treasury Secretary Timothy F. Geithner aims to keep major banks afloat by relieving them of their bad assets.

It uses an unprecedented and innovative approach that attempts to tap into the wealth of private investors to augment cash, loans and guarantees provided by the Treasury, Federal Reserve and Federal Deposit Insurance Corp., according to industry and federal sources.

But it is the program’s goal of enticing private investors into purchasing the bad loans through the promise of potentially robust profits that already has fallen under a shadow because of the backlash in Congress against lavish bonuses and pay at AIG and other financial firms that received bailouts.

Worries on Wall Street that Congress may seek to limit the profits that investors earn on the deals or impose other restrictions is causing reluctance among major investors who might participate in the program.

On Saturday, the Connecticut attorney general revealed that the bonuses given to top AIG executives actually totaled $218 million, $53 million more than the company previously disclosed, in a development sure to fire up further outrage in Congress.

The Senate returns this week to debate its version of a bill that would recoup most of the bonuses earned by Treasury-bailout-recipient employees, through steep taxation.

Besides intimidating potential private investors in the toxic-loan-disposal program, the political furor also raises major doubts about whether the Obama administration will be able to get more funding from Congress anytime soon to replenish the Treasury’s $700 billion bank-bailout fund - a move that likely will be necessary at some point for the toxic-loan program to succeed.

Hugo Dixon, analyst at Breakingviews.com, a British financial think tank, said the firestorm has created a danger for the world economy and financial system.

“Outrage over the $165 million in bonuses has turned financiers into devils and further undermined Geithner’s credibility,” he said. “That will make it harder for Obama to ask Congress for more funding to bail out banks. But until U.S. banks are shored up, the whole global economy will feel wobbly.”

Treasury’s bank-cleanup program appears designed to circumvent obstacles in Congress to some extent, by relying heavily on financing provided by the Fed and FDIC. Congress would not have to authorize the loans provided by the Fed to investors under one part of the program, with only the funding provided by Treasury to cover any losses at the Fed coming out of the bailout fund.

A proposal to expand the FDIC’s funding for disposing of bank assets by $500 billion is pending in Congress and has garnered far less opposition than an anticipated request for additional Treasury bailout funds. The FDIC is widely trusted and respected in Congress for its long-standing role in handling failed banks.

Under the bank-cleanup plan, such private investors as hedge funds and private-equity funds would be enticed into the program because of the availability of cheap financing provided by the Fed, the Treasury and the FDIC.

Under one part of the program, the Fed would provide up to 95 percent of the financing for investors’ purchases of mortgage assets, just as it started doing for private purchases of consumer- and small-business-loan assets last week. The Treasury provides a relatively small amount of funding to protect the Fed against losses on the sales.

The Fed’s consumer-loan program is aimed at leveraging $200 billion of Treasury funding to kick-start up to $1 trillion in loan sales to private investors. Similarly, the toxic-loan program would leverage from $75 billion to $100 billion in Treasury funds to kick-start up to $1 trillion in mortgage-loan sales.

Under another part of the program, the Treasury would be a co-investor in the mortgage loans along with private investors, who would use loans from the Fed to augment their loan purchases. If the loans rise in value, both the government and the private investors would profit. Investors would not be expected to absorb any losses on the deals beyond the amount of cash they put into it, however.

But while the program is innovative and intriguing to many on Wall Street, analysts see potential problems because of the attempt to harness private profits at a time when Congress is harshly rebuking financial firms that engage in such profiteering.

For example, private-equity funds and hedge funds cater to some of the highest-paid executives and wealthiest investors in the world. Moreover, these wealthy funds are extremely secretive and jealously guard information about their pay, perks and profits.

Jeff Meli, analyst at Barclays Capital, said efforts to revive the defunct markets for mortgages and other loans will have a hard time getting off the ground because of fear the government will intervene and prevent investors from making profits.

“The government has recently altered the rules of several of the key programs and proposed altering others, to the potential detriment of banks and investors,” he said.

Investors already showed some reluctance to participate in the consumer-loan-sale program launched by the Fed last week, which is considered a prototype of the toxic-loan program. Only $4.7 billion in loan assets was purchased from among the $200 billion the Fed offered for sale.

“The government is urging the private sector to get the economy moving by helping defibrillate the securitization markets and buying up crummy assets from banks,” said Breakingviews’ Rob Cox. “When the government comes around with yet another offer of cheap capital, are you going to take it?”

Mr. Cox said investors could end up getting publicly skewered whether they make money or lose it.

“If they make a packet [of money], they could be lambasted for profiteering at the taxpayers’ expense. But if their bets don’t pay off, they could be hauled over the coals for losing taxpayers billions,” he said.

While the Fed’s program is attractive to many investors because of its potential to offer returns of more than 15 percent a year, “that’s probably enough to irk some congressman, especially if the buyers pay out some of the profits to their staff in bonuses,” he said.

The risks for hedge funds looking to take toxic assets off of bank books is significant, he said. Hedge funds typically would structure the deals so they could potentially double their money, and then give their leading partners 20 percent of the profit.

“How would politicians react?” Mr. Cox asked. “There is a danger that Congress will be tempted to use the taxpayer financing of these two initiatives as a way to impose greater regulation of the banking and investment industries. … Anyone tempted by the government’s latest offer should bear the capriciousness of this funding source in mind.”

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