CAP’s Michael Ettlinger, Andrew Jakabovics, and David Min have put together a set of recommendations for improving Treasury Secretary Timothy Geithner’s public-private investment fund (PPIP), which aims to clear banks of their toxic assets. They raise one question, in particular, that definitely needs to be addressed: Will investors who purchase mortgage-backed assets have any responsibility to participate in the administration’s mortgage modification program?:

Of specific concern is that the administration’s new mortgage modification program could be undercut by the PPIP’s Legacy Loans Program. The administration’s new Home Affordable Modification Program, or HAMP, requires participating loan servicers — including all future recipients of funding from the $700 billion Troubled Asset Relief Program approved by Congress late last year…to work with at-risk homeowners to modify their loans in cases where modification preserves more value for the mortgages in the lenders’ portfolio than proceeding to foreclosure. Under the LLP, however, many of those loans are destined to be sold to investors who currently are under no such obligation to make mortgage modifications.

This really needs to be sorted out. One potential solution is to simply have the loan purchasers “play by the rules” of the modification program, and receive the same benefits for successful modifications. That sounds reasonable, as it would be a shame if the bank plan stepped all over the administration’s extensive efforts to halt foreclosures.

According to the Obama administration, one of the problems in addressing the economic crisis is that no mechanism exists for taking over large, complex financial institutions. The administration has actually crafted a plan that would grant the Treasury Secretary such power, which it may present to Congress.

Today, Kansas City Fed President Thomas Hoenig said that new legislation is all well and good, but in the case of at least some big firms, that power already exists:

There has been much talk lately about a new resolution process for systemically important firms that Congress could enact, and I would encourage this be implemented as quickly as possible, but we do not have to wait for new authority. We can act immediately, using essentially the same steps we used for Continental.

It’s unclear to which firms Hoenig thinks this authority is applicable. Since AIG is still, technically, an insurance company, it would seem to fall outside the sphere of any existing power that Treasury has. But maybe the administration really doesn’t need some new mechanism to take over a Citigroup or a Bank of America.

This brings us back to the IndyMac example. IndyMac was successfully re-privatized last month, after it had been taken over and cleaned up by the Federal Deposit Insurance Corp. (FDIC). For his part, Hoenig alluded to a similar situation at Continental Illinois, which was taken over by the FDIC in 1984. This week, Elizabeth Warren’s Congressional Oversight Panel also presented Continental as an example for the administration to study:

Another option is government reorganization of troubled financial institutions using conservatorships, as in the case of Continental Illinois in the U.S. and the financial crisis in Sweden in the 1990s. This approach entails an in-place reorganization in which bad assets are removed, failed managers are replaced, and parts of the business are spun off.

In the end, it’s probably best that Congress formally structure some new authority for unwinding large, financial institutions, instead of Treasury relying on the exact same system used for IndyMac and Continental. After all, those were just banks, not globally entwined financial behemoths, and they were only cleaned up, not broken into smaller entities. But the underlying premise remains — the federal government, in one way or another, needs to find a way to unwind the firms that are “too large to fail” and too weak to succeed.

Earlier this week, we questioned whether or not the stress tests that the nation’s biggest banks are undergoing will actually reveal anything we didn’t already know. If early reports from the bank examiners are any indication, the answer is a resounding no. The New York Times reports:

[T]he banking industry, broadly speaking, seems to be in better shape than many people think, officials involved in the examinations say. That is the good news. The bad news is that many of the largest American lenders, despite all those bailouts, probably need to be bailed out again, either by private investors or, more likely, the federal government. [...] Regulators say all 19 banks undergoing the exams will pass them. Indeed, they say this is a test that a bank simply will not fail: if the examiners determine that a bank needs “exceptional assistance,” the government, that is, taxpayers, will provide it.

Yves Smith at Naked Capitalism asked, “so did you get that? They all will be declared to pass in some form, no matter how dreadful they really are,” because “if the remedy is putting in more Federal dollars, rather than a receivership, then the fiction that the money is not being wasted must be preserved.”

The Times also laid out the tests’ conditions, confirming that they are not all that stressful. The “adverse” scenario envisioned by the examiners is “unemployment rising to 10.3 percent by next year, home prices falling an additional 22 percent this year, and the economy contracting by 3.3 percent this year and staying flat in 2010.” Unfortunately, this scenario could absolutely come to pass.

If this is indeed the way in which the stress tests play out in the end, then the Obama administration will have missed a golden opportunity to label insolvent banks as such, and thereby justify taking them over and breaking them up. As Nouriel Roubini said yesterday, “the institutions are insolvent. You have to take them over and you have to split them up into three or four national banks, rather than having a humongous monster that is too big to fail.”

By taking the stress tests seriously, the administration would have had every rationale for doing just that. Instead, it seems that the tests will be used to paper over the banks’ problems, while leaving the door open for further capital infusions.