In his speech this morning to the London School of Economics, Bernanke indicated that the Federal Reserve may resurrect the original concept of the Troubled Asset Relief Program–buying troubled assets.
The basic idea is the same as its always been: banks hold so many assets of unknown and unknowable values that their are perceived as extremely unstable. To put it more bluntly: outsiders fear banks are still mismarking assets way above their actual value, so they won’t trust the balance sheets. “Well capitalised” is just read as “lying about our financial health.”
The solution to the problem is basically to allow banks to replace those highly questionable assets with unquestionable assets: government guarantees, Treasuries and cold hard cash. Basically, the government will step in, overpay for the assets, giving good money for bad assets.
Bernanke describes three ways to give the banks good assets in exchange for their bad assets:
- Have the government buy the bad assets directly,
- Have the government guarantee the value of the bad assets, or
- Have the government fund “bad banks” that would buy the bad assets.
Each has the same effect: the banks get healthier buy pushing the risk of those bad assets onto taxpayers.
We’ve marked up Bernanke’s speech so you can more easily see where he says this:
However, with the worsening of the economy’s growth prospects, continued credit losses and asset markdowns may maintain for a time the pressure on the capital and balance sheet capacities of financial institutions. Consequently, more capital injections and guarantees may become necessary to ensure stability and the normalization of credit markets. A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions’ balance sheets. The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending.
Should the Treasury decide to supplement injections of capital by removing troubled assets from institutions’ balance sheets, as was initially proposed for the U.S. financial rescue plan, several approaches might be considered.
- Public purchases of troubled assets are one possibility.
- Another is to provide asset guarantees, under which the government would agree to absorb, presumably in exchange for warrants or some other form of compensation, part of the prospective losses on specified portfolios of troubled assets held by banks.
- Yet another approach would be to set up and capitalise so-called bad banks, which would purchase assets from financial institutions in exchange for cash and equity in the bad bank.
These methods are similar from an economic perspective, though they would have somewhat different operational and accounting implications. In addition, efforts to reduce preventable foreclosures, among other benefits, could strengthen the housing market and reduce mortgage losses, thereby increasing financial stability.