WASHINGTON — The government's second backstop of Bank of America Corp. shows the shape of things to come for the rest of the financial services industry.
Academics, lawmakers and observers said it laid bare the priorities policymakers have: adding more capital to banks, rebooting a plan to buy or guarantee troubled assets, and requiring banks to agree to systematic modifications.
"We are going to see more of this," said Mark Zandi, the chief economist of Moody's Economy.com Inc.
A greater focus on toxic assets could solidify in the coming weeks, observers said.
Federal regulators began pushing last week to find a way to use the remaining Troubled Asset Relief Program to guarantee or remove illiquid assets from banks. So far, the Obama administration, which takes office today, has said little about how it plans to use the remaining $350 billion of funds.
But many said the B of A backstop once again highlighted that just capitalizing banks was not enough, and that a broader solution is necessary.
"This could cause the new administration to come in and say, 'Why don't we do the asset purchases?' " said Robert Clarke, a former comptroller of the currency and now a partner at Bracewell & Giuliani LLP.
The one detail the Obama team has disclosed to date is that it plans to use at least $50 billion from Tarp for a systematic foreclosure program. But Lawrence Summers, the director-designate of the National Economic Council, also said last week any bank that receives Tarp money — as B of A did — "will be required to implement mortgage foreclosure mitigation programs."
He left it unclear whether those that have already received Tarp money would also be forced to agree to a new program, but some lawmakers said it was likely.
"I can see that the next administration will try to make these modifications programs mandatory, not only going forward but retroactively as well," said Rep. Scott Garrett, the lead Republican on the House capital markets subcommittee. "I'm pretty darn sure that there is language in all these loan documents that each of these banks signed initially to get Tarp I dollars that they are subject to any changes. In other words, the federal government could change that, and retroactively impose additional requirements such as this."
The government could also announce a new round of capital investment to banks — though doing so would automatically trigger tougher requirements for recipients. Mr. Summers said last week that banks that receive additional funds would have to show how they have used them for added lending.
But most of the debate in Washington was centered on how the government could get back into the asset-buying business. Many said asset guarantees — such as the $118 billion in guarantees offered to B of A — could be offered to more banks.
Federal Reserve Board Chairman Ben Bernanke raised the prospect last week, when he suggested offering loan guarantees as part of the second installment of Tarp funds.
But several observers said such an approach also had drawbacks, noting that it does not solve the main problem: taking bad assets off banks' balance sheets.
"Letting them go forward with this stuff on their balance sheet means there's a huge cloud over their balance sheet," said Richard Herring, a professor of finance at the University of Pennsylvania's Wharton School of Business. "It makes it difficult for anyone to value or trust them and they're essentially funding nonproductive assets."
Mr. Zandi agreed, saying "guarantees aren't enough by themselves."
"They are not enough to bring private capital into the system, and that's what fundamentally has to happen before the system will find its footing," he said. "The answer is price discovery. Private capital will come in when there is some clarity with respect to the value of the system's balance sheet."
Some industry representatives raised concerns about the Federal Deposit Insurance Corp.'s involvement in any guarantee. Under the backstop for Citigroup Inc., the FDIC could take as much as $10 billion in losses. The B of A deal leaves the FDIC on the hook for potentially $2.5 billion, though it is to receive a premium of $1 billion under the deal.
"If there is a support for a single institution, it should really come from Tarp, and not from the FDIC's insurance fund," said Jim Chessen, chief economist at the American Bankers Association. "There needs to be a discussion with the industry about the extent to which the debt guarantee program should be expanded beyond its current structure."
FDIC Chairman Sheila Bair has endorsed an alternative idea from Mr. Bernanke: setting up a bad bank that buys troubled assets from other institutions (See related story.)
Such a solution would establish prices for troubled assets and allow banks to move them off of their books.
"What you need is really a good-bank/bad-bank split," Prof. Herring said.
But Chris Low, the chief economist at First Horizon National Corp.'s FTN Financial Capital Markets, said pricing remains problematic whether the government does it or another entity is created to do so.
"The risk is that the pricing in the market, which essentially allows for a huge increase in nonperformance, turns out to be accurate, in which case it will prove to have been a really bad bet," he said.
Other observers, however, were equally concerned about what the government could require banks to do to prevent foreclosures. The industry has agreed to voluntary initiatives, but insisted modifications must be made on a case-by-case basis. Ms. Bair has proposed a program that would offer loan guarantees if lenders agreed to systematic modifications.
But Mr. Summers' letter does not appear to offer any kind of carrot in the form of loan guarantees. Both Citi and B of A were required to agree to systematic modifications as part of their backstops. Other banks are next, observers said.
"I think you're seeing a lot of policy interest in favor of loan modifications," said Oliver Ireland, a partner at Morrison & Foerster LLP and a former Federal Reserve Board lawyer.
"It's come out of the FDIC, out of the Congress, and I think you're probably going to see more of that to come."
Some said it is more likely that, rather than retrospective requirements, the government would offer something similar to the Bair plan, which included incentives for servicers.
The Obama administration "wants to do more foreclosure prevention and loan modification, and stop these foreclosures, and we think that's absolutely necessary to get to the base of the problem here," said Rep. Mel Watt, a top Democrat on the House Financial Services Committee. Asked what else policymakers could do to stabilize the financial markets, Rep. Watt offered his own plan.
"Pray," he said. "I just think we're in such unprecedented territory that it's going to take some positive reinforcement for the markets and for people to go back out and start buying again and participating. That's just where we are."