Private Capital: The Bailout Wildcard

NEW YORK (Fortune) -- Fixing the banks is only the start.

Treasury Secretary Tim Geithner is scheduled to announce his financial sector stabilization plan in a speech Tuesday morning. Geithner is expected to announce multiple programs, including government guarantees of losses on some assets and greater assistance for troubled homeowners.

But with legislators up in arms about the cost of the fiscal stimulus bill, stabilizing the banks is no simple matter. Geithner will have to try to restore the functioning of troubled credit markets - while holding down the cost for taxpayers.

"We want to get the private sector to take responsibility for a situation that in many ways was created in the private sector," said Larry Summers, a top economic aide to President Obama, in an interview on CNN Monday.

"If the government is going to be putting money at risk, we want to make sure somebody in the private sector is willing to take the same risk the taxpayers are being asked to take," Summers added.

With banks still struggling under the weight of toxic assets, markets for mortgage-related securities still locked up and U.S. house prices in free fall, luring back private funds will require a deft touch.

"The administration is having to juggle three different chain saws," said Brian Olasov, a managing director at McKenna Long & Aldrige, a law firm in Atlanta. "The key question is, does the plan make it attractive for the private sector to participate?"

For that to happen, Geithner must show support for a greater flow of investor funds into key areas such as the markets for mortgage-backed securities, auto loans and asset-backed bonds.

Need to jump-start securitization

Olasov says plans like the Federal Reserve's Term Asset-Backed Lending Facility, or TALF hold great promise for restarting private credit flows. Under the TALF program, buyers of triple-A rated securities backed by credit cards, student loans and other assets can swap those bonds for Treasury securities that they can use to get new financing.

According to several reports, federal officials are considering expanding the types of securities eligible for the TALF as well as related plans to include residential and commercial mortgage securities.

"I'm very hopeful that we'll see some new efforts to restart the market for mortgage-related assets," said Ed Gainor, a lawyer in the finance practice at McKee Nelson in Washington. "The policymakers are beginning to appreciate the bulk of loans weren't made on balance sheet, which is why you have to do something for the securitization markets."

The decline of securitization -- the process by which loans are bundled on Wall Street and resold as bonds to investors around the world -- has so far gotten less attention from the Treasury Department and on Capitol Hill than the problems at big banks such as Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500).

Yet in the earlier part of this decade, much more credit was created in these markets than by banks simply originating loans and holding them on their balance sheet.

By 2006, the securitization process was responsible for more than twice the volume of loans being made through more conventional lending, said Mark Sunshine, the president of middle-market lender First Capital in Boca Raton, Fla.

In a speech last year, Geithner -- then the president of the Federal Reserve Bank of New York -- said that by early 2007, assets in the so-called shadow financial system of hedge funds, investment banks and so-called conduits such as structured investment vehicles outstripped those in the traditional banking system.

Since then, the process has gone into reverse with the collapse of asset values. Banks have been tightening their lending standards, resulting in a sharp slowdown in loan production. And an even bigger fall in volume has come in the securitization markets that had been providing much of the financing for buyers of houses, cars and other goods.

Sunshine points out that between the first quarter of 2007 and the third quarter of 2008, bond issuance fell 93% in asset-backed markets, 73% in corporate debt markets and 47% in mortgage-related areas.

"Issuance has just fallen off the cliff," said Sunshine. "The reality is that the banks don't have the infrastructure or the capital to lend in the kind of volume to make up for the collapse of the credit markets."

Creating new bond insurers to get the job done right

Of course, merely recognizing that fact doesn't make it easier to fix the problem. While players in the securitization markets hold out much hope for TALF and programs like it, they also note that the Fed and Treasury have already tried various remedies that haven't had the desired effect.

Still, alphabet soup-sounding plans aren't the only possible answer. Sunshine said he believes the government should start new bond insurance companies that would provide, for a small fee, guarantees on the value of newly securitized assets.

He said these companies would do the work of researching and monitoring the credit of bond issuers, giving the would-be buyers of these assets -- such as pension funds, for instance -- assurance that they aren't taking on too much risk.

Sunshine said it makes little sense for the government to turn its funding toward existing bond insurers. The problems at Ambac (ABK) and MBIA (MBI), which have lost huge sums of money over the past 18 months and suffered huge declines in market value, suggest that the companies at the very least have failed to do what the bond market expected of them.

Another much-discussed plan calls for the government, perhaps in conjunction with private funds, to create a so-called bad bank that would absorb some troubled assets from banks.

How Geithner might implement this plan remains unclear, though Olasov said he believes it's imperative that officials try to put such a bank in place -- even if they need to make changes later.

"The market badly needs price discovery," Olasov said. "The values are so hard to judge that you're not going to be able to get out of this situation without a range of values being made available."