Risky Business

"If you look at the kinds of deficits they are predicting, these are enormous amounts of money," says Wharton finance professor Franklin Allen, who warns of higher inflation and interest rates as a result. "I think what they are doing is extremely risky. Because there are so few precedents, I don't think people fully understand how risky it is."

The new programs have a reasonable chance of rekindling the market for toxic assets, he says, adding that he would nonetheless not be surprised if they fail, leaving taxpayers holding the bag. "When they first suggested [buying toxic assets] last fall, I thought the government would make money. But now the economic situation is so bad it may not be clear. I wouldn't be surprised if they lost substantial amounts of money out there." Temporary nationalization might be the best approach to the banking problem, he suggests, arguing that while bank stocks would become worthless, the bad assets could be removed from their books and the banks could then be turned in to healthy public companies again.

The administration's theory is that removing toxic assets from banks' books will ease worries about bank solvency, spurring a flow of new capital to the banks so they can lend. But it's not certain they will lend even if they have the cash. "They're not making loans because on one hand, Congress is saying lend, lend, lend, and on the other hand, regulators are saying build capital, build capital, build capital," Wachter notes.

Getting lending started may be a chicken-or-egg dilemma, adds Wharton finance professor Itay Goldstein. The problem: Even if it has plenty of money, a bank may be reluctant to lend for fear that other banks will not join in. He describes a case of a bank considering a loan to a company that does business with another company that also needs a loan. If the second company cannot borrow, it may not pay money it owes the first company, causing that firm to default on its loan. Worried about this, the bank may be reluctant to lend even if thinks its borrower is healthy. "It's kind of a self-fulfilling belief," he says.