Plan to Buy Banks' Bad Loans Founders

By DAMIAN PALETTA and DEBORAH SOLOMON WASHINGTON -- A government program designed to rid banks of bad loans, part of a broader effort once viewed as central to tackling the financial crisis, is stalling and may soon be put on hold, according to people familiar with the matter. View Full Image Bloomberg News FDIC Chairman Sheila Bair on Wednesday said banks may now lack incentive to sell bad loans. The Legacy Loans Program, being crafted by the Federal Deposit Insurance Corp., is part of the $1 trillion Public Private Investment Program the Obama administration announced in March as a way to encourage banks to sell securities and loans weighing on their balance sheets to willing investors. But prospective buyers and sellers have expressed reluctance to the FDIC about participating for fear the program's rules will change in a political atmosphere hostile to Wall Street. In addition, some banks that might have sold troubled loans into the program earlier in the year have become less eager as they regained a sense of stability. PPIP was to be split between the FDIC program, which would buy whole loans, and one run by the Treasury Department focusing on securities. Treasury is expected to push ahead with its plan -- the larger and more substantial of the two -- and could begin purchases sometime this summer. But the size of that program could be smaller than initially envisioned, government officials say. The scaling back of the FDIC program is potentially good and bad news for investors, indicating that the health of the financial system -- while improving -- remains fragile. Government officials are still concerned about distressed assets, including residential and commercial real-estate loans, which continue to rot banks' capital. FDIC officials said Wednesday some losses had not yet peaked and government officials believe banks still hadn't fully recognized the value of some distressed assets on their balance sheet. But, at the same time, administration officials say they believe the program to purchase toxic securities mightn't be as integral to a recovery as it once seemed. Markets seem to have stabilized and banks appear more able to digest losses associated with the troubled securities. The program's announcement and the release earlier this month of stress-test results of the country's 19 largest banks helped stabilize public fears about the sector. The stress tests looked closely at banks' exposure to certain securities, such as real-estate holdings, and required some firms to improve their capital positions to withstand further losses. Banks have been able to raise close to $40 billion in new capital in the second quarter, stabilizing their financial position. At a Wednesday news conference to discuss the condition of the banking industry, FDIC Chairman Sheila Bair hinted at the program's uncertain future, without providing details. "There are a couple of factors that are still at play here as we try and develop this structure," Ms. Bair said. She added: "Banks have been able to raise a lot of new capital even before taking more aggressive steps to cleanse their balance sheets, so the incentives to sell may be less." People familiar with the matter say the FDIC is expected to delay a test run of the program that was set to take place next month. The program could be put on hold in the near future, people familiar with the matter said. FDIC officials had initially believed the program could buy as much as $500 billion in loans. The program has also been controversial. Bank trade groups asked the FDIC to allow banks to use the program to purchase their own assets, which some felt could allow banks to game the process. Ms. Bair on Wednesday said that would never have been allowed to happen. The Treasury and FDIC programs were developed in response to widespread fear that the banking sector didn't have enough capital to absorb future losses on bad bets made at the height of the housing bubble. Government officials felt the programs would allow the banks to get rid of their assets and then use the proceeds to bulk up on their capital reserves. Both programs would be boosted through leverage provided by government funding or guarantees. Now, officials say it is hard to gauge how much demand there might be to both buy and sell assets. One complication is that the Obama administration still hasn't given a definitive answer as to how, or whether, various executive compensation restrictions developed in recent months might apply to PPIP participants. The Treasury wants to exclude participants from the Troubled Asset Relief Program rules, which restrict bonuses and other pay, but hasn't yet made a final decision. Government officials "hoped and believed that each of the programs would work, but I think they were realistic enough to know that this is an unprecedented situation, and if you try everything you can, some of it is not going to work," said Douglas Elliott, a fellow at the Brookings Institution. Investors are worried about interference from Congress, which could balk at the sight of Wall Street firms making fat profits from a government rescue program. The American International Group Inc. bonus flap and the strong-arming of banks and hedge-funds who were Chrysler LLC creditors have also given pause. Another reason is concern about government scrutiny related to potential conflicts of interest. A recent law that allows the special inspector general of TARP to conduct audits of participants in the public/private partnerships spooked some investors, Ms. Bair said. "Treasury will need to issue regulations, I think, to clarify those issues before we will have comfort by the participants," she said. Senior Treasury officials weren't keen on the FDIC's program because of the large gap between potential buyers and sellers. In fact, some Treasury officials didn't want the FDIC program to even be created. Treasury is currently selecting asset managers to run the handful of funds it plans to create, which will enjoy unprecedented levels of government financing. A team of Treasury staffers has been poring over the more than 100 applications the government received and has whittled the list down to about a dozen finalists. Some of those firms have started making presentations to Treasury officials about how they would operate the funds. Write to Damian Paletta at damian.paletta@wsj.com and Deborah Solomon at deborah.solomon@wsj.com