Geithner Bailout Plan May Speed Bank Failures

Treasury Secretary Timothy Geithner's bailout plan includes a 'stress test' for banks receiving new government aid, which could identify new weaknesses.
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More banks could fail as a result of the government's plan to test the health of prospective recipients before doling out new federal aid -- and maybe that's part of the point, analysts say.

The government will require so-called "stress tests" for banks with at least $100 billion in assets as a means of determining whether they need capital, Treasury Secretary

Timothy Geithner

said in unveiling the next stage of the financial bailout plan on Tuesday. While Geithner was vague on exact details of the plan, the stress test could be used as a way to allow certain financial institutions to fail, says Quincy Krosby, chief investment strategist at The Hartford.

"There seems to be a growing concern that perhaps we do need to allow banks to fail if the systemic risk and the ensuing doesn't replicate what happened after

Lehman Brothers'

demise," she says.

Nancy Atkinson, a senior analyst at Aite Group, an independent research and advisory firm, also says she suspects "there could be some more banks that, rather than be bailed out, could fail."

"I think that the government is going to be looking very closely at the asset base of each of these banks and ... looking at the write-offs and reserves for loans and making sure they're adequate," Atkinson says. "Where the surprises are going to come is when they really have to dig into these items."

Geithner said the new bailout plan sets up a Financial Stability Trust that evaluates pressure on banks and offers them capital assistance based on that evaluation. In addition, Geithner proposed a joint public-private investment fund of up to $1 trillion to begin valuing troubled "legacy" assets on banks' balance sheets.

Furthermore, the program expands the previously announced Term Asset-Backed Securities Lending Facility (TALF), which will facilitate lending by buying existing securities. The program will also provide support to families facing foreclosure and work to stimulate small-business and community lending.

The possibility of bank failures as a result of the stress tests is one of several concerns regarding the new bailout package. Markets tanked on Tuesday taking down large banks such as

Bank of America

(BAC) - Get Report

,

Wells Fargo

(WFC) - Get Report

,

Citigroup

(C) - Get Report

and

JPMorgan Chase

(JPM) - Get Report

. Bank investors were hoping for a government-led "bad bank" that would buy up toxic assets still weighing down financial institutions' balance sheets, rather than the hybrid, public-private fund.

The government's plan to incentivize

distressed investors

to purchase the bad assets has been ill received over confusion as to what would be fair pricing for the assets.

"It's almost as if

the government want

s to do everything else but that, because that's the most difficult job," Krosby says.

Krosby says if the government's stress tests signal a break with its previous policy, which "has been, essentially, 'We're going to keep these institutions alive.'" Because of the shift in message, investors once again face uncertainty about the prospects of firms that have received bailout money, she says.

"Does that mean that too big to fail is no longer the orthodoxy?" she asks. "These banks will be trading vehicles until we decide: What do they mean? What are they doing, and what do they propose?"

Atkinson says the failures won't necessarily be the largest banks or the smallest community banks, but "there are still quite a few of them that we could find that are in financial trouble and they just haven't surfaced yet."

"I don't think that we bottomed out," she says. "I don't think we identified all of the problems on all the books yet."

Gary Townsend, the president and CEO of Hill-Townsend Capital, an investment management firm that focuses on bank stocks, says stress testing has long been employed by regulators. For Geithner "to include it in the context that he did ... struck me as an absurdity or, worse, a club that they would use to force companies to do irrational things."

"It could be that good things come out of the stress test," says Townsend, who is a former examiner with the Federal Home Loan Bank System.

He says that many times examiners are inexperienced and "use stress testing to force a bank to sell assets or sell subsidiaries and do things that are obstructive of value -- all because of a stress test

that yields a particular result."

Of course, given the accelerated pace of

bank failures

, few would be surprised to see additional financial institutions go. Nine banks and thrifts have failed so far in 2009, compared with 25 failures for all of 2008. As of the third quarter, there are 171 "problem" banks on the Federal Deposit Insurance Corp.'s watch list.

One positive aspect of the stress test and the vague framework Geithner outlined is that it could serve as a means to better deal with a failure by a major institution -- which federal officials lacked when Lehman Brothers failed, and when the federal government stepped in and forced the sale of

Bear Stearns

to JPMorgan last March.

"The government is going to do its best job to make sure that the fallout from

failure by a major institution is contained," says Kevin Petrasic, a former Office of Thrift Supervision lawyer and senior associate with the Banking and Financial Institutions Group at law firm Paul Hastings. He said that an entity that buys bad assets could serve that function.

Such an institution could play the same role that the Federal Deposit Insurance Corp. currently plays with deposits, said Petrasic. The important thing, he said, is "probably not so much having an entity in place as much as having a plan in place."