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Don't forget those toxic assets

Until banks get the bad stuff off their balance sheets, they stand no chance of returning to normal lending.

By Anthony Karydakis, contributor
Last Updated: January 29, 2009: 4:02 PM ET

NEW YORK (Fortune) -- It is hard to ignore the reality that the banking crisis is experiencing another significant flare-up. Headlines are becoming scary again, with questions now raised about the future of institutions (see Bank of America) that had been somewhat shielded from the brunt of the initial storm that broke out last September.

At the core of the latest disturbing twist of events is the fact that banks, while in the midst of a severe recession, continue to be weighed down by an enormous amount of toxic assets on their balance sheets that policymakers somehow never got around to address.

At the onset of the financial market crisis that broke out last September, mopping up those toxic assets quickly became the Treasury's declared first line of attack to contain the banking system's rapidly deteriorating situation. They were the focus of the entire $700 billion TARP project that the Treasury and the Fed rushed through Congress at the beginning of October.

And, then, silence fell. In an abrupt turnaround, the Treasury announced in mid-November that the TARP funds would not be used to absorb the banks' toxic assets but would be redirected toward programs jump-starting consumer lending and spending.

The perplexing implication of the Treasury's change of focus was that, somehow, the continuing presence of such assets on the banking system's balance sheets was no longer viewed as a big problem and could be allowed to linger on, while other priorities were targeted.

The trouble is that the toxic assets did not melt away on their own and they contaminate the ability of banks to redress the quality of their balance sheets. Until the banks do so, they stand virtually no chance of returning to more normal lending activity.

Data released earlier in the week show that lending among 10 of the 13 biggest beneficiary banks of the TARP program contracted by an additional 1.4% in the fourth quarter. With the housing market offering little hope of stabilization over the next two to three quarters, there is no rational reason to expect the toxicity of mortgage-related assets to decrease.

The most disturbing aspect of the latest intense phase of the banking crisis is that now a number of major foreign institutions seem to have also been hit hard. The Royal Bank of Scotland has already effectively been nationalized - the British government raised its ownership stake recently to 70%, up from 58% previously. The other two major U.K. banks (Barclays and Lloyd's Banking Group) are widely feared to be next in line for a similar fate.

It is no accident that the two banking systems that are in the most precarious position among the major industrialized countries, the ones in the U.S. and the U.K., have something very distinctive in common: loads of toxic assets, spun out by the collapse of the respective housing markets.

Other Eurozone countries, as well as Australia, have obviously experienced problems with their banking systems in the midst of what is undoubtedly a global crisis, but none of them is remotely close to those of the endemic kind seen in the U.S. and the U.K.

A quick look at a recent research piece by JP Morgan, based on data from Bloomberg, reveals a frightening reality: On Jan. 20, 2009, the market capitalization of Citigroup (C, Fortune 500) was $19 billion, vs. $255 billion in the second quarter of 2007, while that of Barclays (BCS) was $7.4 billion, vs. $95 billion two years ago.

Similar comparisons for JP Morgan (JPM, Fortune 500), $85 billion now vs. $165 billion then, RBS (RBS) at $4.6 billion now vs. $120 billion then, Goldman Sachs (GS, Fortune 500) at $35 billion vs. $100 billion, Morgan Stanley (MS, Fortune 500) $16 billion vs. $49 billion, and UBS (UBS) at $35 billion vs. $116 billion. (While the numbers for the British banks may have been skewed somewhat adversely by the weakening of the pound during that period, the key message of those comparisons is hard to miss).

No plan to address the serious bind the banking system is in can succeed unless it deals directly with the problem of the toxic assets. In the U.K., the concept of nationalizing the banks is not viewed as a dirty word, as it as in the U.S.

Given the considerable experience of many European countries with nationalized industries at various points in recent decades, the government ultimately taking direct control of banks is one of the key options on the table.

In the U.S., though, the idea of nationalization runs contrary to the axiom of "free markets know best," which is fallacious yet still at the core of this country's cultural foundation. So the options for the U.S. are more limited.

Essentially, the solution regarding the banking system's toxic assets will need to include the original concept of a bad bank - or some close approximation of it - that will absorb the bulk of such assets and help gradually restore balance sheets to a semblance of soundness.

The new administration's economic team has already signaled that it is seriously exploring that solution, while having restated at the same time the near-sacred objective of keeping banks private.

While actual nationalization of the banks remains a no-go area of possible outcomes, a quiet, technical nationalization of a number of institutions cannot be ruled out if things continue to deteriorate. After all, another label for the same action is always easy to invent.

One thing, though, remains certain: Any solution to the banking crisis will need to go back to the basics and deal with the issue of the toxic assets. The problem is much too stubborn and pervasive to be ignored, and time is running out.

Anthony Karydakis is a former chief U.S. economist for JP Morgan Asset Management and currently an adjunct professor at New York University's Stern School of Business. To top of page

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