Questions remain over $1trn toxic asset purchase plan

New financial stability initiatives will see US banks required to implement stress tests to strengthen their balance sheets and the establishment of a pseudo "bad bank" fund that could buy up to $1 trillion of illiquid assets off of struggling financial institutions, the US Treasury has announced.

In a speech given in Washington DC yesterday, Treasury Secretary Timothy Geithner laid out the Obama administration's latest scheme to restart the flow of credit, strengthen banks and provide aid for homeowners and small businesses.

Among the proposals outlined as part of the new Financial Stability Plan were measures to "require banking institutions to go through a carefully designed comprehensive stress test. We want their balance sheets cleaner, and stronger. And we are going to help this process by providing a new programme of capital support for those institutions which need it," Geithner explained.

Although Geithner did not explicitly state plans to create a bad bank outright, he announced the establishment of a Public-Private Investment Fund, which will target the legacy loans and assets that are burdening financial institutions by providing government financing to leverage private capital and revive capital markets.

"By providing the financing the private markets cannot now provide, this will help start a market for the real estate-related assets that are at the center of this crisis. Our objective is to use private capital and private asset managers to help provide a market mechanism for valuing the assets," Geithner said.

The fund, which "should provide up to one trillion in financing capacity, but start on a scale of $500 billion" will ultimately "help provide a market mechanism for valuing the assets." Geithner did not, however, specify exactly how the fund would assist valuation, only stating that the Treasury is exploring a range of different structures for the programme, without mentioning the exact role public funds will play in the initiative.

Initial reaction from analysts was one of disappointment, given both the lack of detail Geithner provided around the new measures and the relatively conservative monies been allocated toward the purchase of distressed assets.

"The size of the public-private partnership fund for toxic assets may be a little too low at $500 billion to $1 trillion. We think the number of toxic assets out there in the market is between $2 trillion at the low end to $3 trillion at the high end, but we realise there could be political exigencies in place that prevent policymakers from pushing through too big a number right now," commented Ajay Rajadhyaksha, US head of fixed income at Barclays Capital in New York.

Up to another $1 trillion may be committed to a consumer and business lending initiative to kick-start secondary lending markets, bring down borrowing costs and restart the securitisation markets that are considered vital to get credit flowing again.

Closer cooperation between the fragmented US financial regulatory agencies will initiate a more consistent, realistic, and forward looking assessment about the risk on balance sheets, Geithner promised, with firms that need additional capital being able to access a new funding mechanism that uses monies from the Treasury as a bridge to private capital.

Under the terms of the facility - which will see this Treasury investment placed in a new Financial Stability Trust - every public dollar drawn upon will have to be "used to generate a level of lending greater than what would have been possible in the absence of government support. And this assistance will come with terms that should encourage the institutions to replace public assistance with private capital as soon as that is possible," he added.

The Federal Reserve also announced a substantial expansion of the Term Asset-Backed Securities Loan Facility (Talf), which could increase the size of the programme to as much as $1 trillion and broaden the eligible collateral to encompass other types of newly issued AAA-rated asset-backed securities, such as commercial mortgage-backed securities and private-label residential mortgage-backed securities.

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