Watchdog Warns Toxic Assets Remain a Major Danger to Financial System

Signs abound that the worst of the recession is over: Stocks have been surging, the rate of job losses has slowed, so it seems that the economic apocalypse has been averted.

Government programs such as the $787 billion stimulus and last fall's $700 billion Troubled Asset Relief Program have so far been successful, the Obama administration says.

Except, the Congressional Oversight Panel warns in its August report, TARP never actually bought any troubled assets.

"It is likely that an overwhelming portion of the troubled assets from last October remain on bank balance sheets today," the panel's report says.

Those bad assets are still there, rotting away on banks' books, making banks reluctant to ratchet up lending, and maybe, the watchdog warns, paving the way for another financial meltdown.

"We are now 10 months into TARP," the panel's report notes, "and troubled assets remain a substantial danger to the financial system."

Even hundreds of billions of taxpayer dollars later, they say, the country could still be susceptible to the same problems that existed in the first place -- especially if the economic situation deteriorates again.

"If the economy worsens, especially if unemployment remains elevated or if the commercial real estate market collapses, then defaults will rise and the troubled assets will continue to deteriorate in value," the report says. "Banks will incur further losses on their troubled assets. The financial system will remain vulnerable to the crisis conditions that TARP was meant to fix."

True Extent of Banks' Troubled Asset Problems Unclear

On top of that, the report says, no one knows the true extent of the troubled asset problem. The International Monetary Fund, for example, estimated that toxic asset losses could total $4 trillion.

"There is no doubt that the banks holding these assets expect substantial losses, but the scale of those losses is far from clear," notes the Panel.

The Treasury Department has already taken steps to deal with the problems posed by toxic assets, but with little tangible success.

Earlier this year the administration unveiled the Public-Private Investment Program, a two-pronged approach to address both toxic securities and toxic loans. Under the plan, the government would match public capital with private capital in an effort to jumpstart the market for these bad assets. But the plan has yet to get off the ground.

In fact, the FDIC recently postponed the toxic loans program, saying that the banks' ability to raise capital -- as evidenced by the federal regulators' stress tests for the country's 19 biggest banks -- made it unnecessary.

Toxic Assets Still a Threat to Small Banks, Panel Warns

But the Congressional Oversight Panel warns that toxic assets still present a serious threat, especially for small banks. The bad assets for small banks are usually whole loans, not addressed by the PPIP.

Moreover, small banks have a tougher time accessing capital than their larger banking counterparts and carry a greater number of commercial real estate loans, which have a higher chance of going bad. Therefore, the watchdog suggests, "vigilance is essential." The panel also reiterates their view that the stress tests should be repeated if economic conditions deteriorate.

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