U.S. May Use Capital Injections for ‘Bad’ Asset Plan (Update1)

March 11 (Bloomberg) -- The Obama administration plans to use capital injections as an incentive to get U.S. banks to sell distressed securities to investors.

The private investors will also get federal loans to buy the assets, in a two-pronged strategy intended to revive trading in mortgage-backed debt. Treasury Secretary Timothy Geithner said in an interview with PBS’s Charlie Rose show yesterday “it requires making sure there’s capital available to the system, that these banks have the incentive to start to move this stuff, that there’s a mechanism available” to finance investors.

Geithner’s initiative reflects a bet that it will be cheaper to provide taxpayer financing than have the government buy the assets outright, as contemplated by the Bush administration.

“In conception, it’s reasonably well designed; the question is in the execution,” said Randal Quarles, a former Treasury undersecretary who now works at the Carlyle Group in Washington. “There are a lot of details that remain to be worked out in pushing things in these two directions.”

Since the Treasury’s $700 billion bank-rescue package was approved last October, regulators have had difficulty devising a pricing mechanism for the toxic securities. That complication, coupled with the potential cost, caused then-Treasury Secretary Henry Paulson to drop his effort to deal with the assets.

$1 Trillion

While the Obama administration considered creating a so- called bad bank to buy the assets, that idea was also scrapped in favor of a public-private partnership. Private investment managers would run the funds that purchase the securities, in a program that may reach $1 trillion with government financing.

Regulators aim to use the stress tests they began last month on the 19 biggest U.S. banks, and any ensuing injections of Treasury funds, to encourage them to write down the illiquid assets from the levels on their books, according to people familiar with the government’s discussions.

The reviews, which include assessments of how much more capital lenders may need to weather the economic downturn, are scheduled to be completed by the end of April.

Geithner today said “we are implementing a series of aggressive initiatives to stabilize and strengthen our financial system to support economic recovery, and we look for complementary actions around the world.” He made the remarks in a statement on a meeting of the Group of 20 major industrial and emerging nations he’s attending later this week in the U.K.

Paulson Legacy

Representative Melissa Bean, an Illinois Democrat and member of the House Financial Services Committee, said the failure to devise a method of taking the distressed securities off banks’ books “limited” the success of the Bush administration’s bailout.

“If we can leverage private sector dollars with our public sector money, we can have a critical impact,” Bean said.

Under the proposal Geithner is pushing, the Treasury would provide both banks and outside investors, such as private equity firms and hedge funds, with incentives to jumpstart the market, according to the people.

Private investors would get government financing, perhaps through a program similar to the Federal Reserve’s Term Asset- Backed Securities Loan Facility, that would let them leverage their money at least two or three times, the people said.

The leverage increases the potential rewards while reducing the risk, allowing investors to pay a higher price for the toxic assets. The government, in turn, could inject more bailout funds into the banks to help replenish their capital and acknowledge losses.

‘Weeks and Months’

In his Charlie Rose interview, Geithner said the Treasury will provide “precise” details of the plan in the next few weeks. “People will see how it’s going to operate and then it will go into place over the following weeks and months,” Geithner said.

Stocks worldwide yesterday staged the biggest rally of the year after Citigroup Inc. said it was having its best quarter since 2007. The S&P 500 Financials Index surged 16 percent, the biggest one-day jump since Nov. 24; it added another 0.9 percent as of 1:20 p.m. in New York today. It’s still down about 27 percent since Feb. 9, the day before Geithner outlined his planned overhaul of the financial-rescue plan.

After sinking below $1 a share last week, Citigroup jumped 38 percent as Chief Executive Officer Vikram Pandit wrote in an internal memorandum that the bank, which reported five straight quarterly losses, was profitable in the first two months of 2009.

‘Dramatically Worse’

Geithner said that as the crisis unfolded, some bank directors “made things dramatically worse by continuing to pay out really unjustifiable bonuses to their senior executives and they were losing tens of billions of dollars.”

“That made this basic crisis of confidence much worse, because people understandably looked at that and said how could that be tenable?” Geithner said.

Fed Chairman Ben S. Bernanke yesterday urged a sweeping overhaul of U.S. financial regulations to smooth out the boom- and-bust cycles in markets.

“We should review regulatory policies and accounting rules to ensure that they do not induce excessive” swings in the financial system and economy, the Fed chief told the Council on Foreign Relations in Washington.

Bernanke also reiterated that the central bank, Treasury and other regulators “will take any necessary and appropriate steps” to ensure banks have capital to function well under distressed economic conditions.

“Governments around the world must continue to take forceful and, when appropriate, coordinated actions to restore financial market functioning and the flow of credit,” Bernanke said. “Until we stabilize the financial system, a sustainable economic recovery will remain out of reach.”

Referring to the stress tests regulators will use to determine whether banks need more capital, Bernanke said an adverse scenario “involves unemployment averaging over 10 percent for a period, which we view as certainly well within the realm of possibility.” That outcome isn’t the “central tendency” of most forecasts, he said in response to an audience question.

To contact the reporters on this story: Robert Schmidt in Washington at rschmidt5@bloomberg.netBradley Keoun in New York at bkeoun@bloomberg.net.

To contact the editor responsible for this story: Chris Anstey at canstey@bloomberg.net