Health of banking lies with Obama stimulus honeymoon

Whatever comes out of the new president's efforts, there is no guarantee yet that the US financial system is safely out of the woods.

The honeymoon period for the US president, Barack Obama, might turn sour if he does not move quickly to get the sick US economy moving, and with it the rest of the world, it seems. In essence, this means fixing the US banking system as the major shot in the nation's economic arm. Mr Obama's honeymoon will be an extra long one. It will take a good while for "worship" to decay to "adulation", and on to something like "critical assessment". This should be enough time, we all hope, for the economy to kick-start. When it comes to policy over slick public relations, the pressure to deliver something for the US economy will take more than a momentary change of mood. Meanwhile, a self-reinforcing downwards economic spiral is becoming entrenched.

His economic policy advisers are working hard to finalise a three-pronged revamp of the troubled asset relief programme (TARP), which is highly likely to include a "bad bank" to remove problem mortgage assets from bank balance sheets. The ambitious bank and credit markets plan is intended to be an essential complement to the US$825 billion (Dh3.03 trillion) fiscal stimulus package. It behoves GCC central banks to watch closely how the US experiment works out, as it could be a role model of action should there be massive failures among Gulf financial institutions.

The centrepiece of the plan appears highly likely to be the bad bank or "aggregator bank", as some have described it, which would be capitalised with TARP funds. In addition, the banks that sell toxic assets into the bad bank are likely to receive part payment in capital notes or warrants in the bank, which will add a first-loss cushion and, in effect, allow a grace period against mark-to-market losses until the assets mature.

The aggregator bank will then be leveraged up in one of two ways. The first is to leverage up the amount of assets and risk the bad bank can take off bank balance sheets, and for the bank to issue its own government-guaranteed, asset-backed commercial paper and medium-term notes to gear up by as much as a 10-to-one ratio. Money market funds would be the most natural target investor base. The second, which is still being discussed, is for the US Federal Reserve to lend against the assets purchased as its collateral, after surrendering a premium for the Fed. Lending its balance sheet to help remove legacy assets from the banks is a highly sensitive policy path for any central bank.

In addition to the bad bank scheme, the Obama administration's sweeping proposals to stabilise the banking system and restart the credit markets will contain two other critical components. The first will be between $50bn and $100bn in TARP funds set aside for foreclosure mitigation and mortgage modifications. And the second is likely to include government guarantees or "insurance wraps" around some of the impaired assets. This would leave them on banks' balance sheets but would remove the worst of the asset risks. The banks would continue to manage and finance the assets as well as absorb first losses.

The "how" and "which" of assets that would be included in an insurance wrap rather than being sold to the TARP-capitalised bad bank have not been finalised. However, the triggers are likely to be the nature of the asset - whether mortgage-related or real estate, whether legacy assets left over from the illiquid mortgaged structured paper, and whether the assets are held by "systemically important" banks as against smaller or midsized lenders.

In an echo of the favoured war rhetoric of the former US defence secretary, Donald Rumsfeld, officials speak of "leaning forward" in describing the remaining pieces and shape of the intended bank rescue scheme that they believe is essential to an economic recovery by restarting the credit markets, helping find a bottom to the declines in the housing sector, and staving off a deeper recession and deflation risk. And in many ways, the envisioned multilayered and multi-institutional rescue of the banks and credit market has parallels in what were then huge country bailouts during the Asian and Latin American crises of the late 1990s, engineered by the US Treasury and pieced together with the support of the IMF, World Bank and the Bank for International Settlements.

The structures of those bailouts were driven by the need to increase the total funding potentially available and to underscore the consensus across public institutions that helped to reinforce their market credibility. Whatever comes out in the end, there is no guarantee yet that the US financial system is safely out of the woods, and the global uncertainties in this sector remain, as demonstrated, so vividly nearer home with credit defaults and downwards rating revisions of Gulf banks.

Dr Mohamed A Ramady, a former banker, is a visiting associate professor in the finance and economics department at King Fahd University of Petroleum and Minerals in Dhahran, Saudi Arabia.