Will More Loan Guarantees Save the Banks?

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(L to R) Ethan Miller / Getty ; Patrik Stollarz / Getty

What do you when a bank rescue plan fails? You try it again.

Washington policy makers seemed to be moving closer to expanding loan guarantee programs, which have already been offered to Citigroup and Bank of America, to other banks. But in both those cases, the loan guarantee strategy seems to have produced few positive results.

In late November, the government agreed in a deal struck over a weekend, to guarantee 90% of the losses on a pool of $300 billion in loans held by Citigroup. The government insurance was supposed to put the bank back on solid footing. At the time, a number of analysts said Citigroup needed as much as $300 billion in new capital to survive. The government thought insuring the loans, rather than the more costly and politically difficult path of just handing Citigroup money directly, would be enough to stabilize the bank. (Read "Why Your Bank Is Broke")

It hasn't. Instead, the plan seems to have done little to slow fears that Citigroup would have to be broken up or shut down completely. Indeed, the bank has since announced plans to sell off a number of units, including its brokerage division. On the Friday before the insurance plan was struck, Citigroup's stock, a key measure of investors' faith in the institution, stood at $3.77. This past Friday Citigroup's stock finished the day at $3.57.

Bank of America's shares have similarly traded down since it landed its own loan guarantee deal from the government. In that bank's deal, the government agreed to pick up nearly $100 billion in losses. That hasn't stopped the bleeding at Bank of America, either. Bank of America stock, like Citigroup's, has continued to fall. The company's shares closed on Friday at $6.53, down from $7.18 in mid-January when it announced its deal with the government.

It's not clear why the loan guarantees are doing so little to shore up confidence in the two banks. Some say it's because investors fear the problems at the banks are larger than the guarantees they received. What's more, both guarantees involve the two banks taking more losses before the government insurance kicks in. In Citigroup's case, the bank will have to swallow $29 billion more in bad loans before it is protected from further losses.

Another problem is lack of flexibility. Citigroup is just protected against losses in the $300 billion portfolio it sets up with the government. Any losses outside of that loan group are all Citi's. As a result, some investors are worried that Citigroup even with the new guarantees won't have enough capital pay for the loan losses it will have to realize. By some estimates, Citigroup's shareholder capital could be wiped out if just 2% of its loans go unpaid.

"Actual money is better for these banks," says Alex Pollock of the American Enterprise Institute. "Because they can use it to offset losses wherever they come up."

Nonetheless, the idea of new loan guarantees as the solution to fix the banking crisis appears to be gaining momentum in Washington and abroad. Earlier in the week, Treasury Secretary Timothy Geithner seemed to have struck a deal between the FDIC and the Federal Reserve to roll out a new phase of the bank bailout plan that would include both guarantees and direct asset purchases. The latter plan is favored by the FDIC and is often called the "bad bank" approach, because the government would set up an institution to buy up all the loans or bonds that are backed by borrowers who are nearing or in default. Sources say the FDIC has been against the loan guarantee plan, and only signed onto the Citigroup and Bank of America deals reluctantly.

But on Friday, reports surfaced that Geithner was thinking about shelving the bad bank approach for now, and just moving forward with the loan guarantee program. If it does, Washington officials would not be alone. Last week, Britain rolled out its own loan guarantee program as part of that country's effort to help its struggling banks.

"Loan guarantees are always seductive because they seem like they will be free for the government," says Pollock. "But in fact, if you have to pay out, they can turn out to be very expensive."

Multimedia: The IndyMac Panic

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