Bernanke suggests U.S. buy toxic assets from banks

LONDON (Reuters) - Federal Reserve chief Ben Bernanke on Tuesday suggested the incoming Obama administration may want to retool the government's approach to fighting the credit crisis and tap a $700 billion financial rescue fund to sop up bad assets on the books of banks.

By Tamawa Desai

In his first policy speech since early December, Bernanke said that while an expected U.S. fiscal stimulus package could provide a "significant boost" to the economy, the government may need to inject more capital into banks and consider steps to clear the financial system of toxic mortgage-related debt.

"Fiscal actions are unlikely to promote a lasting recovery unless they are accompanied by strong measures to further stabilize and strengthen the financial system," Bernanke said at the London School of Economics.

U.S. President-elect Barack Obama, who takes office in a week, is pressing a skeptical Congress to let his Treasury Department access the remaining $350 billion.

Bernanke said the government could consider using the money to buy up bad debt, as originally intended, or could offer asset guarantees or set up a so-called bad bank to take over the assets as a way to strengthen a shattered financial system and help the U.S. economy pull out of its year-long recession.

"The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending," Bernanke said.

John Bovenzi, chief operating officer for the Federal Deposit Insurance Corp, told a congressional panel removing bad assets from bank balance sheets should be "a key component" of how the final $350 billion in bailout funds is used.

A rising tide of U.S. mortgage delinquencies has saddled the global banking system with distressed assets, choking off lending and sending many economies tumbling.

Outgoing U.S. Treasury Secretary Henry Paulson and Bernanke had pressed Congress in September to approve the $700 billion bailout fund so the government could buy up the bad debts to stave off a financial calamity. Paulson, however, quickly turned his focus toward purchasing equity in banks, which he has argued was a quicker way to shore up the system.

FED STILL HAS 'POWERFUL TOOLS'

Bernanke said how governments respond to the financial crisis would determine the timing and strength of recovery, and he stressed that the Fed still had 'powerful tools' to deploy even though it has cut benchmark interest rates to near zero.

When the U.S. central bank dropped overnight rates to a range of zero to 0.25 percent in December, it said monetary policy would now focus on the size of its balance sheet, which has exploded as officials pumped funds into stressed markets.

Analysts have said the Fed's policy marks a form of 'quantitative easing' of the sort Japan employed earlier this decade to break free of a persistent deflation.

Bernanke, however, sought to differentiate the Fed's "credit-easing" approach with the policy pursued in Japan.

"The Federal Reserve's credit-easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for businesses and households," he said. In contrast, the Bank of Japan focused on the quantity of bank reserves.

This difference means the U.S. strategy does not lend itself to targeting the quantity of excess bank reserves or the money supply, Bernanke said.

DON'T WORRY ABOUT INFLATION

In outlining the Fed's emergency tools, Bernanke said a program to support consumer and small business credit, which will begin providing loans to investors next month, could be expanded or widened to cover additional classes of securities.

He also reiterated that the Fed was considering buying longer-term government debt.

Some analysts have warned that the Fed's aggressive efforts may end up fueling inflation.

Bernanke, however, played down that concern, noting that many of the Fed's lending facilities will wind down as demand for the money winds down. With many of the assets held short-term in nature, a "significant shrinking" of the Fed's balance sheet could happen quickly, he said.

"We see little risk of inflation in the near term; indeed, we expect inflation to continue to moderate," Bernanke said.

In answer to a question, Bernanke said he was expecting the economy to stabilize later this year, but suggested it could take longer for the labor-market to heal.

"I am hopeful that later in 2009, depending on factors, particularly including financial and credit markets, we should begin to see some stabilization in the economy. It takes a while though for labor markets to recover."

(Additional reporting by Swaha Pattanaik and Mike Peacock; Writing by Mark Felsenthal and Tim Ahmann; Editing by Diane Craft)