How the government might acquire banks' toxic debt is still being ironed out, but one approach suggested by Treasury Secretary Henry Paulson involves a process under which financial institutions would propose a price for their mortgage-backed securities and the government would choose the lowest bids.
If banks sell at the proposed price - say 50 cents on the dollar - accounting rules would require firms to take the losses on their balance sheets before getting the damaged assets off their books. For weaker banks buffeted by the deepening credit crisis, the losses may hinder their ability to go out raise capital, make loans and ultimately stay afloat, according to industry experts.
"There is a risk that there will be bank failures to come," said Vincent R. Reinhart, former director of the Federal Reserve's monetary affairs division.
While the reverse auctions could help banks set a clearing price for mortgage-related assets, Reinhart said, that "price doesn't mean that every financial firm will be solvent" after those assets are sold.
Another risk is that if the auctions set too low a price for mortgage-related assets, other institutions with bad debt may be forced to take the distressed valuation onto their books under mark-to-market accounting rules, Reinhart said. Mark-to-market rules involve adjusting the price of an asset to reflect its current market value.
"If the auctions don't go well, it will drag down everybody's balance sheet who marks to market," Reinhart said.
The financial system has been battered by $500 billion in losses from the mortgage mess, and the International Monetary Fund has estimated the price tag could ultimately top $1 trillion.
The crisis has forced 11 federally insured banks and thrifts into failure this year. Another 117 banks and thrifts were considered to be in trouble in the second quarter - the highest level since 2003 - with the total assets of troubled banks tripling to $78 billion, according to the Federal Deposit Insurance Corp. The agency does not disclose which institutions are on its list, but on average, 13 percent of banks that make the list fail.
Christopher Whalen, senior vice president and managing director of Institutional Risk Analytics, has predicted that 110 banks with assets worth $850 billion are in danger of failing by next summer. He said the Treasury Department's rescue plan hasn't given him reason to be more optimistic.
"If the government comes in and buys these assets at a discount and you're a strong bank, you don't care because you're getting cash and you go off and do business. If you're a weak bank and you take a big hit, you may not have that option," Whalen said.
He said the government may decide that the only option to save some banks is to pay full price for the assets in exchange for equity, which could be sold later.
But that could be risky because if the government pays too high a price, it will be difficult if not impossible to go out and sell the assets for a profit in the future, meaning any losses incurred would be absorbed by taxpayers. But paying too little also is problematic because banks will be forced to take steeper losses that they may not be able to recover from.
"The government should be able to arrange to pick a price that helps the banks but also that allow the government to turn around and make a profit down the line," said Marvin Goodfriend, professor of economics at Carnegie Mellon University.