WASHINGTON — While the Treasury Department is expected to unveil more details Wednesday on stress tests for the largest institutions, the verdict on that plan is already in — the tests will do little to restore confidence in banks, and may undermine it further.
Instead, a chorus of observers said the Treasury needs to concentrate on other solutions that could have a practical impact. First on that list: removing bad assets from banks' books, no matter the cost.
"You have to clean up the balance sheets," said Michael Bleier, a former Federal Reserve Board lawyer who is now a lawyer at Reed Smith. "That is pretty much a sine qua non for getting people to feel comfortable."
The idea has been discussed for more than six months and embraced by two administrations, and though there are real hurdles, politics may be the biggest roadblock.
Every means of clearing illiquid assets is likely to be expensive — and deeply unpopular.
"In the end, the taxpayer ends up taking a loss," said Robert DeYoung, a finance professor at the University of Kansas' School of Business. "The taxpayer/investor can purchase the bad assets through an aggregator bank or a public-private partnership or whatever. You know they're going to pay too much for the assets. That's the only way to get them off of the books."
When Treasury Secretary Timothy Geithner on Feb. 10 unveiled the administration's plan for dealing with the financial crisis, he said the administration intended to set up a public-private partnership to purchase bad assets from struggling institutions.
But since then no details have emerged, and the Treasury and federal regulators appear to be focusing most of their efforts on crafting a stress test to help guide future capital injections. That the Treasury has not settled on a way to price assets that currently have no market is likely part of the reason regulators have been dragging their feet on an asset plan.
But the time for worrying about a proper price for the assets has passed, observers said. And the more time it takes to tackle the issue directly, the higher the ultimate cost.
"You have to be prepared for the possibility it just doesn't really ever generate any reasonable return, and it turns into the equivalent of a total loss," said Timothy R. McTaggart, a partner at Pepper Hamilton LLP. "But the idea is to take these assets out of the system; you stabilize the marketplace and the banks and you try to handle the overhang."
Mr. Bleier, a former counsel at Mellon Financial Corp. when it created its own "bad bank" in 1988 for nonperforming assets, acknowledged that pricing is difficult. But as banks continue to take writedowns, prices are coming more into focus, he said.
"As time passes it will get easier to figure out those prices, because you're constantly marking them down over time," he said. "At some point you'll get to the level where they do clear."
Since former Treasury Secretary Henry Paulson first mentioned an asset-purchase plan last September, two possibilities have been clear: either the government will underpay for illiquid assets, forcing massive writedowns at banks, or it will overpay, costing taxpayers more.
Regulators since then have appeared unable to choose which path to take. But sources agree it does not ultimately matter — as long as they choose one quickly. In either scenario, there are ways to cope with negative impacts.
For example, the government could force massive writedowns on existing assets, effectively purging the system of its bad assets, and then recapitalize those banks that cannot attract capital from the private sector.
Conversely, the Treasury could overpay for assets, providing banks a windfall. Though expensive and unpopular, if such a move were successful in unclogging the credit markets, the political fallout would likely fade over time. President Obama could also attempt to assuage public anger by explaining what is at stake.
"The bad bank is the quickest and cleanest, but it's not the most politically feasible, because it looks like the banks are getting a subsidy," said Paul Miller, an analyst at Friedman, Billings, Ramsey. "They need to articulate better to the population why a bad bank is the best solution. If they won't, they will be dealing with this one by one, which will take longer."
At this point, most sources said government officials have little to lose by taking decisive action.
"We can't get past the politics," said Karen Shaw Petrou, managing partner of Federal Financial Analytics. "The Obama administration will just have to decide what policy it thinks is best and make the politics work for them. If there were a good answer — an easy answer — Secretary Paulson would have taken it."
A third, less direct option remains. Rather than attempting to buy bad assets, the government could give enough fresh capital to institutions to compensate for all the potential losses on those assets.
"The fastest way and simplest way to get over" the problem of pricing bad assets "is to recapitalize the banks up to that amount so that they can feel confident to be able to sell these assets off and take the hits," Prof. DeYoung said. "It's straightforward."
James Wilcox, a business professor at the University of California, Berkeley, said that adding even more capital to the system will make benefits of the Treasury capital infusion program — which he says to date have simply kept the industry afloat — more visible, including enabling institutions to do more lending.
"The situation we have been in has been a little like pouring water into a bathtub that has a leak. You might not see the level of the water changing very much, but that's because … it's been draining out someplace else," said Prof. Wilcox, a former chief economist at the Office of the Comptroller of the Currency. "To the extent that the first Tarp actually offset some of the leak, the next installment of capital may well have much more visible effects. To the extent that the first Tarp covered up the leak, then the additional capital might well spur more lending."
Others say the Obama administration should also address mark-to-market accounting — either scrap it, suspend it, or make significant changes.
Kip Weissman, a lawyer at Luse Gorman Pomerenk & Schick PC, said policymakers could make a huge impact by easing the "other than temporary impairment" section of the rules, which require assets to be written down to market value permanently.
"One of the problems with OTTI is that once you've marked an asset down, you can't mark it back up," he said. "That's backwards. Once you've marked it down, you should be able to mark back up."
Several observers said the Treasury could help restore confidence fairly easily — by giving concrete details about what it is doing and why. Vague pronouncements are only hurting the system, they said. "They need to start getting more specific and stop raising so many doubts about what they're going to do," said Bert Ely, an independent consultant based in Alexandria, Va. "They can't even be specific about when something's going to be announced. They're getting to the point where they have to stop confusing and stressing out the markets."