Treasury's latest plan faces pitfalls

John W. Schoen Senior producer • Profile • E-mail

After months of speculation and false starts, the Treasury Monday announced a new plan to deal with the so-called "toxic assets" that have been weighing down the financial sector and clogging global credit markets.

The announcement by Treasury Secretary Tim Geithner was greeted by a big rally on Wall Street but leaves unresolved some major hurdles that have plagued the rescue plan since October, when the Bush administration first floated an idea to deal with the troubled assets. And the new plan leaves unanswered the biggest question echoing from Wall Street to Main Street: Will it work?

With private investors still loath to step up and buy mortgage-backed securities and related assets, the latest Treasury plan shifts much of the risk to taxpayers. By partnering with the government, a few big investment funds will have a chance to profit off the toxic assets, sharing any proceeds with the government. But if the investments don't pay off, taxpayers will bear most of the risk.

“There is no doubt the government is taking risks,” Geithner told reporters. “You can’t solve a financial crisis without the government taking risks.”

In addition to the risk of taxpayer losses, there is also the risk that the government could set such a low price on the toxic assets that it could actually worsen the credit crunch.

The new plan will draw on up to $100 billion in funds already approved by Congress under the  Troubled Asset Relief Program, as well as additional funding from the Federal Reserve. The government will match private investment dollar-for-dollar, and the Federal Deposit Insurance Corp. will put up significant backing, up to $6 for every $1 invested, in exchange for a fee.

The FDIC funding will be in the form of “non-recourse” loans, meaning private investors will be allowed to walk away from their investment if it goes bad, leaving the government with the failed investment and any losses on the loan.

After months of preliminary discussions with potential investors, the Treasury is now moving quickly; private firms have to apply by April 10, and the government will respond by May 1. Some of the nation’s biggest money management firms, including PIMCO and BlackRock, are considered likely candidates. The Treasury is expected to limit the list to a half-dozen firms at most.

What's the 'market' price?
At the height of the housing boom, investors couldn’t get enough of the mortgage-backed bonds Wall Street was churning out by the boatload because these investments offered a good return for what seemed like little risk.

But when it became apparent that sloppy mortgage lenders had doled out hundreds of billions of dollars to people who couldn’t pay it back, no one wanted to touch investments backed by mortgages. With no way to sell them, banks are now stuck with trillions of dollars worth of assets they can’t properly value. That’s clogging up the global flow of credit.

Though roughly 90 percent of mortgage holders are still making payments, investments backed by mortgages are selling for only 30 to 60 cents on the dollar. The reason is that — with unemployment rising and home prices falling — no one knows which mortgages will be the next to default. So banks have been forced to write down the value of these investments and take huge losses to cover the write-downs

The Treasury is hoping that by jump-starting the private market with a massive shot of government investment and lending, prices of these assets will stabilize and banks can either sell them off or assign them a more realistic value on their books.

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