The government by itself can't fix the worst banking crisis since the Great Depression, but the Obama administration is betting that when given the right incentives, investors' appetites for profits will help unclog lending and put the economy back on solid ground.
In laying out the government's plan to partner with the private sector to buy as much as $1 trillion in bad assets, Treasury Secretary Timothy Geithner said it was the best option to deal with a vexing problem that has plagued both the Bush and Obama administrations.
The issue: How to get the toxic loans and securities off bank balance sheets so that banks can raise money and lend to creditworthy customers. Without such lending, the economy is expected to remain mired in a recession that is already the deepest in decades.
The alternatives were to let the assets sit and continue to deteriorate and drag down bank balance sheets or have the government buy the assets, putting all of the risk on the taxpayer, Geithner said.
"What our job is is to try to fix this problem in our financial system at least cost to the taxpayer," he told reporters at a briefing.
What remains to be seen is if enough banks and investors will participate to make the program work.
One of the biggest concerns is that amid public fury and congressional action about bonuses paid to employees receiving government aid, investors will be too worried that the rules will change midgame. Rather than take the risk that they, too, will be subject to government involvement in pay and other decisions, investors may instead choose to sit this one out.
"The administration and Congress need to realize quickly either they keep this up and they won't get anybody (to participate), or back off," IHS Global Insight chief economist Nariman Behravesh said, noting if investors participate, the program could help the government avoid nationalizing failing banks.
Indeed, Bill Gross, founder of Pacific Investment Management, one of the nation's largest bond investment firms, said he would participate in the program, saying participation could lead to "double-digit returns."
Investors liked what they heard on the toxic asset purchase program. All 30 stocks in the Dow Jones industrial average rose, pushing the popular barometer of the stock market up 497 points, or 6.8%, to 7776. That was the Dow's biggest percentage gain since Oct. 28 and its 20th-largest percentage gain in history.
That stood in stark contrast to the reaction on Feb. 10, when Geithner announced a broad outline of the administration's plan to tackle the financial crisis and boost the economy. Investors, disappointed by the lack of details, bid the Dow Jones industrial average down 4.6%.
This time, Geithner gave concrete details of the Public-Private Investment Program, a joint Treasury, Federal Reserve and Federal Deposit Insurance Corp. program that aims to take so-called toxic assets, such as subprime mortgage loans, off bank balance sheets. Treasury will commit up to $100 billion from the $700 billion financial rescue plan passed last year. The government will then work with private investors to buy up to $1 trillion in bad loans and securities that are clogging bank balance sheets and inhibiting lending.
"These markets are stuck," Geithner said. Without government incentives, investors are not willing to take the risk and buy the assets, forcing the government to step in.
"We need to move very aggressively to get our financial system back to the point where it's providing the credit necessary for recovery," Geithner said.
He said he is confident that investors will want to be involved but suggested Washington needs to provide more certainty for potential investors.
"For these programs to work, investors have to take risk," he said. "For them to take risk, they have to be more confident than they are today that there are going to be a clear set of rules of the game applied consistently and enforced fairly going forward."
President Obama, after meeting with Geithner, Fed Chairman Ben Bernanke and FDIC Chairwoman Sheila Bair at the White House, urged patience.
"It's not going to happen overnight," he said. "There's still great fragility in the financial systems. But we think that we are moving in the right direction."
Still, administration officials said they are moving quickly. White House spokesman Robert Gibbs said the first purchases should happen "quite soon."
There are two parts of the government program, one to buy pools of loans, such as mortgages, and one to buy securities, financial investments that are backed by bundles of mortgages and other kinds of loans.
In the loan program, a bank will approach the FDIC and let it know it has a pool of loans to sell. The pool of loans will be auctioned by the FDIC to private bidders. Say the highest bid is $84 for every $100 in a risky mortgage. Of that, FDIC guarantees $72 in debt financing to the private investor, Treasury invests $6, and the investor kicks in $6.
The securities program will work in a similar fashion. Approved fund managers will raise private capital, which the government will match while also providing supplemental loans. The fund manager then buys the securities.
Eligible securities include mortgage-backed securities that were originally rated AAA or are currently highly rated.
Standard & Poor's said of $2.8 trillion in residential mortgage-backed securities issued in 2005 through 2007, it has downgraded about $882 billion and an additional $1.3 trillion could be downgraded. About 43% of the securities that originally carried S&P's highest AAA rating have been downgraded.
Some expressed concern that taxpayers are paying too much and investors too little. "The plan seems to offer little incentive for private investors to participate unless the subsidy is made so rich that it comes at the expense of the taxpayer," House Republican Whip Eric Cantor of Virginia said.
But Geithner said the government has to take on risk to entice investors to participate. "We have to get the incentives right so we can get private capital coming in," he said.
Fellow Democrats support the plan. "We must act," Senate Majority Leader Harry Reid of Nevada said. "One risk we will not take is standing on the sidelines and doing nothing while a bad situation gets worse."
Creating such incentives may have been made more difficult by the rush on Capitol Hill to write legislation to prevent firms receiving government aid from giving bonuses to employees. Last week, the House of Representatives passed a measure to tax such bonuses at 90%. The move came after it was revealed that insurance giant AIG, which has received pledges of about $180 billion in federal assistance, provided large bonuses to some employees in the division that produced AIG's massive losses.
Such action may lead some investors to walk away from future dealings with the government.
"Private investors are going to be very wary about going into partnership with the government given all the strange things coming out of Congress these days," said David Smith, an associate professor of commerce at the University of Virginia, counting himself among those who question if the plan will work.
Noting "deep anger and outrage" in America, Geithner said the administration is working with Congress to make the legislation more palatable before it heads to the Senate.
The new toxic asset program does not include limits on executive compensation for participants.
Risks for banks
Some analysts also said it's unclear if banks will be willing participants in the program if the private funds make very low bids on their assets. That will force banks to take even bigger losses, further weakening their balance sheets. "I don't see any incentive for the banks to sell unless they already have written down these assets aggressively," Smith said, noting that in prior situations in both the USA and abroad, governments have forced banks to sell their bad assets.
Christopher Whalen, founder of research firm Institutional Risk Analytics, said the usual buyers of securities and debt, such as hedge funds, don't have much money left because investors have withdrawn so much cash.
That means the only investors willing to buy these assets would be so-called vulture investors, who would want the securities at a steep discount. In that scenario, banks would balk at selling and recording big losses.
At the same time, funds don't usually have the kind of staff that is required to manage a portfolio of distressed assets. "These assets will have to be decomposed and liquidated, and it's a very costly process that not too many investors have the expertise to do," Whalen said.
But some investors appear to be waiting in the wings to get in on the government program.
"You have many vultures circling the carcass," said Jeff Matthews of hedge fund firm RAM Partners. He notes the plan puts the hedge funds and other private buyers in the role they do best, which is "kicking the tires" of the investment and determining what price to pay.
"The hedge fund makes money, the government makes money," he said. "The government becomes a partner with smart buyers who want to make money for themselves."
Cathy Vann, president and owner of Ontra, bought bad real estate loans and assets from the government during the savings and loan crisis when more than 700 banks were seized by the FDIC. She has formed a partnership called USA Recovery Group with eight other financial firms that work with the government to try to profit from bad loans.
"We will look for at least 20 to 25 cents (on the dollar) returns on these assets. Otherwise, it isn't worth the trouble," Vann said.
Barry Fromm, CEO of Value Recovery Holding, was one of the lead contractors working with the FDIC buying up bad assets during the savings and loan crisis and said he also looks forward to bidding on the assets.
"We already do this kind of work — we have debt collectors, real estate specialists, lawyers, brokers and appraisers — all ready to start working with the government," Fromm said.
Taxpayers could also reap a reward from their investment if the value of the assets increases. The funds that will be created to buy the assets can exist up to 10 years and longer with Treasury's approval, according to the program's guidelines.
The toxic asset program is one part of the government's attack to thaw credit markets and prop up the economy, which has been in a recession since December 2007. Treasury has previously announced plans to help homeowners and small businesses, while the Federal Reserve is working to resuscitate the securitization market to facilitate lending for consumers, such as credit cards and student and auto loans.
The government is also analyzing the health of banks and promising to shore up the largest banks to make sure they can withstand an even more severe economic downturn. And Congress earlier this year passed a $787 billion stimulus package, which includes tax breaks and infrastructure spending.
Ethan Harris, co-head of U.S. economic research at Barclays, said the Fed's program and stimulus take pressure off of the latest Treasury program.
"We do have to judge these bailout plans as a whole," Harris said. "Two out of three ain't bad."
Contributing: David Jackson, Richard Wolf; Gogoi reported from New York; Krantz from Los Angeles