By Richard T. Pratt, Chairman of the Federal Home Loan Bank Board 1981-1983; R. Dan Brumbaugh, Jr., Deputy Chief Economist 1983-1986; and Bowers W. Espy, Deputy Director of the Office of Economic and Policy Research 1981-1983, the Federal Home Loan Bank Board.

The Current Debate: Expand the Troubled Asset Relief Program (TARP) versus Nationalization

The Administration, the

Federal Reserve

System, and the Federal Deposit Insurance Corporation (FDIC) are addressing many critical elements necessary to resuscitate credit markets and facilitate economic stabilization and recovery. They understand that a fully functioning banking system is essential to that end. The initiatives announced by the Secretary of the Treasury on February 10, 2009 take important steps toward that goal.

A key initiative, the Capital Assistance Plan (CAP), would provide needed capital from the TARP to the banking system via the government purchase of convertible preferred securities from institutions deemed viable. Based on most estimates of future bank losses, however, available funding through the TARP is woefully inadequate to meet the capital needs of banks and substantial additional congressional funding will be required at a time when our federal deficit is soaring.

Concern over the Administration's plan has given rise to a growing call for massive bank nationalization. Nationalization should not be viewed as an overall solution to the banking crisis, but reserved for select institutions that have no hope of recovery. The FDIC already has a long history of closing -- in effect nationalizing -- failing banks on a case-by-case basis, and that process will continue.

The wholesale nationalization of a large segment of the banking industry based on current market conditions is not feasible. The primary problems affecting the banking system today are a function of system-wide de-leveraging, dysfunctional markets, and uncertainty about the scale of the current recession. They have caused a major disconnect between the so-called "fair value" and the fundamental value of bank assets based on expected cash flows. A government takeover of any or all of the banking system will not resolve these problems. These issues can only be resolved over time, as economic conditions stabilize.

A comprehensive and efficient way to resolve this crisis is to ensure that the banking system has adequate capital to operate in the current environment, and has the incentives and ability to aggressively resolve problem assets over time. This should be accomplished in a way that does not exacerbate our fiscal deficit and provides adequate oversight of banking institutions.

Our proposal provides a transitional government capital program targeted at the core problem -- how to efficiently deal with impaired assets in the banking system at the least cost to taxpayers.

These assets have the following characteristics: They are large in number, diverse in type, their dollar value (in absolute terms and as a percentage of bank assets) is unprecedented, many will continue to decline in value until the economy improves, and many are structured in a way that makes them currently impossible to accurately value. There is no quick resolution for these problem assets in the current economic environment. Recapitalizing banks and enabling them to work out of these assets over time will minimize the ultimate cost to the taxpayer. The program that we advocate can be implemented without increasing our fiscal deficit, enables aggressive resolution of problem assets, provides substantial oversight, and facilitates new lending to credit-worthy borrowers.

An Alternative Plan: Recapitalize Banks with Preferred Stock Funded by Full Faith and Credit Government Notes

An alternative plan to recapitalize banks can be based on one that helped resolve the savings and loan and banking crises of the 1980s and early 1990s. Then, as now, massive declines in asset values occurred simultaneously with two recessions. Over that lengthy period, there were times in which virtually all savings and loans and some of nation's largest commercial banks were insolvent on a fair value basis. During that time, however, the banking system continued to function, providing adequate financing to credit-worthy borrowers. The program enabled the resolution of problem assets in an orderly fashion over time and in a way that maximized recoverable value while not inhibiting traditional banking operations.

The policies implemented during that period worked. By 1989 Congress was able to provide funds to close the remaining insolvent savings and loans and create the Resolution Trust Corporation (RTC) to work out of the remaining troubled assets. Likewise, the FDIC in the early 1990s was able to close remaining insolvent banks without direct taxpayer assistance.

We recommend that the current administration draw from that experience and model the CAP after the Net Worth Certificate Program that Congress enacted in 1982. Both the Federal Savings and Loan Insurance Corporation (FSLIC) and the FDIC were able to shore up the capital of weak institutions with no cash outlay. The FSLIC and FDIC purchased capital certificates from troubled banks that the agencies deemed viable. They paid for the certificates by issuing FSLIC and FDIC senior notes to the banks. As the banks regained profitability and access to traditional capital markets, the certificates were redeemed in exchange for the agency notes.

William M. Isaac, former Chairman of the FDIC recently stated in a column for the

Washington Post

that "the net worth certificate program was designed to shore up the capital of weak banks to give them more time to resolve their problems. The program involved no subsidy and no cash outlay..... If such a program were enacted today, the capital position of banks with real estate holdings would be bolstered, giving those banks the ability to sell and restructure assets and get on with their rehabilitation. No taxpayer money would be spent, and the asset sale transactions would remain in the private sector where they belong."

Then, as now, the goal was to avoid the unnecessary and excessive taxpayer costs of an immediate resolution. Today's version of the certificate program would allow banks and bank holding companies, ranging from

Citigroup

(C) - Get Report

,

Bank of America

(BAC) - Get Report

and

Wells Fargo

(WFC) - Get Report

down to small local banks, to issue preferred stock to the FDIC that would count as Tier 1 capital in exchange for full faith and credit government notes issued by the FDIC, an unassailable asset on the balance sheet. Participating banks would have the capital necessary to restructure and resume lending. As in the past, there is no debt issuance required by the Treasury. Existing examinations and oversight in conjunction with stress testing will enable the Federal Reserve and the FDIC to monitor individual institutions and ensure progress in restructuring and new lending. To the extent a bank's losses prove insurmountable or the institution is not progressing with restructuring and facilitating new lending, the FDIC can resolve the institution on its timetable with an orderly distribution of assets and liabilities.

Such a program can be enacted quickly under existing authority, provides government control of the crisis and participating institutions, can be applied to banks of all sizes and locations -- local, regional and money center banks -- ensures their ability to facilitate an economic recovery, enables the government to utilize existing resources at both the bank and regulatory level in the resolution of problem assets, and can be accomplished without exacerbating our fiscal deficit. Implementing this plan, in conjunction with the programs already announced and underway by the Administration, can successfully steer our economy back to the path of growth and prosperity.