Treasury plan to buy bank stakes carries risks

Banks don’t have to sell stock to the government. But under the terms of the recently enacted Troubled Asset Relief Program, any bank that wants to sell bad mortgage-backed debt to the government have to give the government, in return, the right to buy some of its stock. Banks that have loaded up their books with these bad mortgage assets may have no choice.

“The only reason they're putting money in those banks and the banks are accepting is that the banks will go broke without it,” said Bill Seidman, former chairman of the Federal Deposit Insurance Corp. “They're not taking this because they love the government. They're taking it because the regulator is saying, ‘You don't have enough capital. If you don't get more capital, we're going to close you down.’”

Some critics suggest that government regulations may be a big part of the problem banks are now facing. The huge losses they’ve booked are due in large part to the heavy writedowns in the value of investments back by mortgages — for which there are no buyers. Most people are still paying their mortgages, so these investments are almost certainly worth something.

But because of the uncertainty about rising defaults and falling home prices, banks are required to “mark” the value of these investments to the “market price,” which may be far less than they’re really worth. Congress recently gave the Securities and Exchange Commission more leeway to relax those accounting standards.

“The SEC has destroyed $500 billion of bank capital by its senseless marking to market of these assets for which there is no market,” said William Isaac, former FDIC chairman. “And that has destroyed $5 trillion of bank lending. That's a major issue in the credit crunch we're in right now. The banks just don't have the capital to start lending right now because of these horrendous markdowns that the SEC's approach required.”

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But allowing banks to assign a higher value to these investments could backfire — by undermining confidence in bank bookkeeping. That’s the main purpose behind the TARP program. The hope is that once the government begins buying these mortgage-backed investments, bankers, investors and depositors will get a better idea of how much capital banks have to work with — and which banks are at risk of going under.

That uncertainty about how much mortgage related assets are worth could also undermine the government efforts to pump money into the system by buying up stakes in banks.

“The problem is if you capitalize the banks that hold these troubled assets — but there’s no clarity or transparency or price discovery process for these assets — then that capital could quickly evaporate,” said David Resler, chief economist at Nomura Securities. “You need to have both.”

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