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U.S. wading deeper into banking industry

The Obama administration is drawing up a new plan to save the banking system, sparking talk of a government "nationalization" of the industry. Here is what is at stake.

The Federal Reserve has cut rates to zero and flooded the financial system with money. Congress has spent $350 billion — and committed another $350 billion — to shore up the battered banking industry. Banks have already booked roughly half a trillion in losses, and analysts say they could be looking at a half a trillion more.

Now the Obama administration is going back to the drawing board to craft a new plan to save the banking system, get credit flowing again and try to pull the economy out of a deepening recession. The new plan could be announced as early as next week.

In his confirmation hearing last week, Treasury Secretary Tim Geithner said the White House is working on a new bank rescue plan. He was short on details, but the massive scope of the problem has prompted talk that the administration may be planning to "nationalize" a large portion of the banking industry.

In its most extreme form, nationalization would mean that the government buys (or takes) all the shares of stock and takes over operations of the company, keeping the profits. Such state ownership is typically a form of socialism; major oil producing countries, for example, have set up state-owned companies to produce and sell oil, using the proceeds to pay for government services.

Nationalization is not unheard of in the United States. When railroads stopped providing intercity passenger service in the late 1960s, the government set up Amtrak to take over those routes. Some countries have state-owned airlines to provide service not available from for-profit carriers.

But that type of broad action is unlikely, analysts say. In fact, the government already has partially nationalized dozens of banks across the country by investing billions of dollars in return for preferred shares, giving the taxpayers a tiny ownership stake in each institution.

The new plan is likely to take the government deeper into the industry's affairs.

Why is the government so involved?

At the heart of the problem is trillions of dollars worth of “toxic assets” owned by big banks that continue to lose value as the recession deepens. As the value of these assets has plummeted, banks have had to cover the losses with capital they might otherwise be lending to business and consumers. That pullback in lending is one of the major causes of the current recession. Until banks can clean up their books and get back on a solid financial footing, it will be hard to get credit flowing again.

What are these "toxic assets"?

In the past, most bank assets were typically direct loans to businesses or consumers. Though those loans defaulted more frequently when times got tough, bankers set aside reserves and wrote off the loans that went bad.

The wave of lending during the past decade was backed by a surge in "securitized" loans that were bundled together, placed into a trust account and then sold off. The buyers were supposed to get paid back — with interest — as the underlying loans were paid off. The bankers who created these trusts believed they had dramatically reduced the risk of default, so banks carried far less in reserve to back up these investments. In some cases, the trusts weren’t even carried on the bank's books.

So why are they now “toxic”?

It turned out the bankers were wrong: The assets backed by loans like mortgages turned out to be much riskier than everyone thought. Some of those mortgages went to borrowers who couldn’t afford them. The computer models used to assess the risk of defaults didn’t include a recession as deep as the one we’re in. And investments backed by a mix of loans turned out to be so complicated that the bond rating agencies that originally blessed them as safe no longer vouch for them. So no one wants to buy them.

If no one wants them, then they’re worthless, right?

Not necessarily — and that question is at the center of the problem. Since they’re not being bought or sold, there’s no market price for them. But many of these investments are backed by loans that are still paying interest and principal to investors. Though mortgage defaults and foreclosures are up sharply, roughly 90 percent of people with mortgages are paying on time.

These mortgage-backed assets come with complex rules about which investors get paid first and which get hit with losses. Because you can’t know how many more mortgages will default, and some mortgages last for 30 years or more, it is extremely hard to predict what many of these assets will be worth in the future.

Wasn’t the Troubled Asset Relief Program supposed to buy up these toxic assets to get them off the banks hands?

That’s what members of Congress thought when they approved the $700 billion package nearly four months ago. The problem came when the Treasury tried to figure out how much to pay for those assets. Since these assets aren’t being traded any more, there’s no market to set a fair price.

Instead, the Treasury gave most of the first $350 billion directly to banks in exchange for stock that pays a fixed dividend. The hope was that taxpayers eventually would get the money back and banks would start lending again. But lending has actually fallen — in part because banks are using the money to offset more losses and in part because the recession has hurt demand for loans.

If the government has swapped cash for stock, doesn’t that mean they’ve already nationalized those banks?

So far the government has been mostly a passive investor, although it certainly can exert influence.

Typically, the government only steps in and takes complete control when a bank is insolvent — meaning its losses have wiped out all of its capital (or may do so soon.) The goal of the current effort is to help banks raise more capital, not take control of them.

Why not just have the government keep buying more stock?

One reason is that it chases away private investors, which is where everyone would prefer banks to raise fresh cash. But if banks have to issue new shares in exchange for government funding, that makes the old shares worth less. That’s one reason bank stocks are trading at such low levels: Investors are worried that if the government buys up too much new stock, their current shares will be worth less.

What else can the government do?

On idea that seems to be gaining ground is a so-called “good bank, bad bank” scenario that would involve creating a government-run “bad bank” to take over toxic assets until the market for these investments improves, which could take years.

Under that plan, the government would take over the worst banks, strip out the bad assets and then sell the remaining “good” bank back to investors, putting it back on a sound financial footing. The major drawback is that existing bank shareholders would get wiped out.

Or the "bad bank" could simply take over the bad assets in exchange for "good" assets like Treasury securities that banks could apply to their capital base. The Federal Reserve has had some success using this model to revive the market for company-issued debt called commercial paper.

The "bad bank" plan has something of a precedent: In the late 1980s, when the savings and loan industry collapsed, the government set up the Resolution Trust Corp. which took over failed S&Ls and sold off their assets. The process cost about $150 billion in today’s dollars, which seems like a bargain solution compared to the current mess.

How much would that cost this time around?

It depends on how you choose to define “troubled assets,” but the $700 billion TARP program would represent only a down payment. A recent report from Goldman Sachs estimates that including assets backed by mortgages, credit card debt, car loans and commercial real estate, the total could run to $5 trillion.

No one in Congress is talking about spending that much money, but the plan could include government guarantees for investors who eventually buy up those assets.

After the very limited success of the TARP plan, the White House seems to be convinced that half measures aren’t good enough. Geithner underscored that point in his testimony last week.

"If our policy response is tentative and incrementalist," he said, "if we do not demonstrate by our actions a clear and consistent commitment to do what is necessary to solve the problem, then we risk greater damage to living standards, to the economy's productive potential and to the fabric of our financial system.”

The harder question may be figuring out which banks to “clean up” and which banks won’t make it no matter what the government does. That uncertainty has also beaten down bank stocks and forced banks to conserve their cash.

Until the full scope of the plan is worked out — and bankers convinced the government is serious about following through with it — that uncertainty will hang over the banking industry and the credit markets, delaying the prospects for an economic recovery.