Fear of "Zombie Banks" Drives Government to Deal With "Toxic Assets"

The financial crisis – a collapse in the normal functioning of the economy which has led to a recession and prolonged slowdown in economic growth – has dominated the news and the federal government’s agenda for months.

Despite the fact that major banks such as Citigroup reported profits in 2009, they still hold piles of bad debt and a debate rages about how to fix their underlying problems.

"Toxic assets"

	Banks made bad loans to people who were unable to pay them, forcing the banks to foreclose on more than 290,000 homes in February alone.

Banks holding these assets have no idea how much they are worth, but the fear is that they have lost billions, maybe trillions of dollars.  The uncertainty has stopped banks from loaning money to businesses and individuals, which hurts the entire economy.

Too many toxic assets can turn banks into “zombie banks” that are not able to survive on their own and need continuing support from the federal government. 

In late 2008, Congress provided $750 billion to help solve the toxic asset problem, called the Troubled Asset Relief Program.  America’s largest banks have received tens of billions in loans from this program, but so far the money has been used to keep the banks afloat, and not address the toxic assets.

Geithner’s plan

	As President Obama's Treasury Secretary, Tim Geithner has a major hand in overseeing the nation's economic response to the recession.

The idea is that with the help of hundreds of billions of dollars worth of government guarantees, private investors will take a risk and buy these assets from the banks, so that the banks don't have to worry about them anymore.

This plan would create "good banks" that don't have toxic assets and "bad banks" that can focus on the mortgages themselves.

Geithner explained on the Charlie Rose show that the government needs to help unfreeze the market for the toxic assets.

“That's why governments have to step in, in financial crises and take risks the market would otherwise not be prepared to make. So with financing, we're confident you're going to see private investors come in and put some capital to work to sort of unfreeze these markets,” he said.

Critics of Geithner’s plan say it will be very difficult for new investors to agree on a suitable price for the toxic assets.

“What I think we are setting up here is a process of negotiations with the banks that believe these assets are worth a lot more than the private sector is willing to pay for them,” Economist Peter Wallison told the NewsHour.

Banks will try to get as much as they can, claiming that they will go bankrupt if they don't get a certain price.  But too high a price would mean that not only are taxpayers rewarding banks for bad decisions, but the resulting debt could force higher taxes and severe budget cuts.

Government takeover

	Bank of America, one of the world's largest banks, has already received billions of dollars in bailout money from the federal government.

Economist and columnist Paul Krugman is in favor of bank nationalization, saying that nationalization gives taxpayers a share in gains made from a bank rescue instead of just putting them at risk.  He also believes it would make banks more responsible. 

This solution is not popular with bankers, however, as a takeover would probably sweep them out of a job and make their stock worthless.

Bank of America CEO Ken Lewis said nationalization would be a “nightmare.”

It would make investors lose faith in all banks, "possibly creating a self-fulfilling prophecy," he said, Reuters reported.

"And government control of large banks would politicize lending decisions and the capital allocation process, damaging the economy."

During its banking crisis in the 1990s, Sweden nationalized its banks and successfully ended their crisis.  Economist Alan Blinder, a critic of nationalization, points out that Sweden had much fewer banks and a less complicated system.