What Obama can do with the banks?

In a few days, U.S. banks will have a new boss in Barack Obama. What will he demand from his sick subjects? That is a huge talking point among bank-stock investors.

After an incoherent start, the Treasury of Henry Paulson launched multiple bank rescues that settled into something of a pattern. Recipients of government aid issued preference shares with an affordable dividend, and the really sick, like Citigroup and Bank of America, passed a portion of future losses to the taxpayer.

But this approach didn't solve the problem: BofA shares are down 81% in a year, despite two government interventions. Meanwhile, Standard & Poor's said Friday that without government support Citi's credit rating would be four notches lower.

Mr. Obama needs to try something new.

Surprisingly, the incoming administration is discussing plans that resemble Mr. Paulson's ideas. The new team is mulling wider use of loss-sharing agreements and buying toxic assets from banks.

For investors, much depends on the terms attached to assistance granted by the new administration. If they are tough, the stocks could get hit. And they may have to be tough to avoid a public outcry. The Obama team is well aware that throwing taxpayer money at the banks is unpopular with the public.

Just as important is the scale of bad asset purchases and loss guarantees. If they are too small, the banking sector doesn't get cleaned up quickly. But if they are too big, the public purse gets strained and popular opposition intensifies.

Looking at the weakness of balance sheets, there is a good chance that credit losses will pile up and banks' capital needs would overwhelm what the new administration can, or wants, to spend.

An alternative strategy would be to nationalize the sickest and restructure their balance sheets by giving a haircut to the banks' creditors. The advantage: It quickly removes problem banks from the market, and takes restructuring out of the hands of unreliable executives. The downside: It prompts panic in the debt markets, hurting healthy banks.

A variation for the government would be seizing banks and restructuring their balance sheets without hurting creditors, before trying to recapitalize them with private money. Granted, that also would be expensive for the taxpayer, given embedded balance-sheet losses, but it might provide a lasting solution for certain banks.

Whatever path the new administration takes, it is likely to demand concessions from the industry on how it pays its staff and how it lends.

For instance, Friday, the Federal Deposit Insurance Corp. proposed extending the bank-debt guarantee to 10 years from three years, as long as the debt is used to fund consumer loans.

If the administration goes too far down this interventionist road, while keeping banks publicly traded, they could start resembling the old government-sponsored entities, like Fannie Mae and Freddie Mac. Investors may remember how that all ended.

(source: wsj)