Banks still at risk from toxic assets

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Despite the billions of dollars the U.S. government has spent bailing them out, many banks are still at risk because toxic assets have not been removed from their books, according to a Congressional watchdog group -- the Congressional Oversight Panel. The panel was created to give another layer of oversight beyond the the Special Inspector General for the TARP and regular audits by the Government Accountability Office.

TARP was created to get toxic assets off banks' books, but so far no one has come up with a plan that works. The Legacy Loan Program was the latest brainchild to help banks clean out their books, but no bank wanted to sign on to it because they didn't want to take the losses. So, instead, TARP is now being scaled down to deal with the toxic assets after a bank fails.

Why allow the banks to wait that long? The Treasury Department conducted stress tests of the largest banks, but did not require similar tests of smaller banks. Based on the report from the Congressional Oversight Panel, it's these smaller banks that may still need another $12 to $14 billion to cope with troubled loans on their books.

Large commercial loans are the primary threat to smaller banks. As owners of shopping malls, hotels and offices default on loans more rapidly, the smaller banks that hold many of these loans will suffer. Experts think the bottom for the commercial real estate market is still three years off. Delinquency rates on loans doubled in the past year to 7 percent. The Federal Reserve expects more companies to downsize and more retailers to close their doors, leaving office and retail space vacant.

The Congressional report said small banks "will need to raise significantly more capital, as the estimated losses will outstrip the projected revenue and reserves." The panel is led by Harvard law professor Elizabeth Warren. "Failure to start the Legacy Loan Program raises concerns about Treasury's strategy," the report states.

Republican Representative Jeb Hensarling, who is on the panel, disagrees with the report's conclusion. He thinks the loss estimates may not be accurate and shouldn't be used to justify more funds. So do we wait until the actual numbers come in, let the banks fail and then try to rebuild the financial system?

That may be exactly what is needed. The FDIC is cleaning up the mess and dealing with the bank failures. The big question is will it be cheaper for the government to bail out the banks up front or close them in an orderly process by selling off the smaller banks to ones that have done a better job of managing risk? Either way, the government is stuck with the bad loans. But at least by closing poorly run banks we clean out the bad managers.

Lita Epstein has written more than 25 books including Reading Financial Reports for Dummies.

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