The Bank Bailout Is Broken

Last year, as the U.S. financial system began to unravel, former Treasury Secretary Hank Paulson used to talk about the bazooka in his pocket. It was a metaphor designed to calm investors anxious about the government's willingness to spend massive taxpayer dollars to save the financial system if really needed. But Paulson's weapon jammed. For despite an array of lending programs by the Federal Reserve and the $700 billion Troubled Asset Relief Program (TARP) passed by Congress during his tenure, Wall Street firms and banks still collapsed left and right last fall.

Now the Obama Administration is effectively saying: Forget the bazooka, let's bring out the heavy artillery. The President's economic advisers believe it is time to hit the reset button on existing bailout programs, and think big. There's no choice given the deepening recession that's driving up jobless rates and home and credit-card defaults. All that in turn is contributing to multibillion-dollar quarterly losses at the likes of Citigroup (C) and Bank of America (BAC).

"Bad Bank" Could Cost $2 Trillion

One big piece of that effort, of course, is the controversial $819 billion package of spending and tax cuts that were approved by the Democratic-controlled House of Representatives on Jan. 28. At the same time, the Fed is ramping up programs to buy securities backed by car, credit-card, and student loans as well as mortgage-backed paper to help thaw the credit markets.

Fixing the banks, Obama advisers argue, will require a more innovative approach than the capital injections into lenders that the Bush team settled on. Fed lending and government cash transfers help, but Bush's advisers backed away from tackling the array of toxic assets that have caused a massive erosion of capital on bank balance sheets and have made extending loans to all but the most creditworthy borrowers unthinkable. "Money is moving throughout the system, but there is increasing recognition that these institutions don't have enough capital to withstand the losses from all the crazy loans they have," says Frederick Cannon, a banking analyst with Keefe, Bruyette & Woods (KBW).

New Treasury Secretary Timothy F. Geithner is exploring the creation of a government-funded "bad bank" to buy up mortgage-backed securities and other troubled assets from banks in hopes of boosting their capital levels so they can begin lending again. Daniel Clifton, Washington policy analyst for Strategas Research Partners, says Treasury is considering starting the bank with $100 billion from TARP, then adding leverage from the Fed and the Federal Deposit Insurance Corp. so $1 trillion in funding is available to buy bad assets. Ultimately, he adds, Administration officials believe they could need up to $2 trillion.

Fixing the banks will almost certainly require far more than $700 billion in TARP funds. Goldman Sachs (GS) analyst Andrew Tilton figures U.S. financial institutions will suffer more than $1 trillion in loan losses—about half of which have been recognized so far. The problem isn't only with residential mortgages. Add in commercial real estate and other poorly performing loan categories, and the banks may hold some $5 trillion in "troubled assets" on their books, he says. New York University's bearish economics professor, Nouriel Roubini, estimates that additional private and public capital of $1 trillion to $1.4 trillion will be needed to recapitalize the banks.

Guarantees vs. Asset Purchases

Another idea being considered by Treasury and White House officials would offer banks federal guarantees that limit their losses on bad assets backed by dud loans, as with Citi and BofA. While this might cost taxpayers as much as buying the banks' assets, guarantees would allow the Administration to avoid the difficult and politically risky step of potentially overpaying for assets now trading at fire-sale prices. In extreme cases, authorities also could put capital directly into the banks in exchange for common equity—pulling off a thinly veiled nationalization of the worst banks.

Analysts say a combination of remedies is likely. "They'll need to create a mix of options," says Karen Shaw Petrou of Washington research firm Federal Financial Analytics. Prying more money out of Congress for expanded bank bailouts will be tough. Yet it's hard to see the economy recovering without healthy banks. Getting there won't come cheap.