David Wessel discusses whether banks can lend and grow without removing toxic asset on their books. (Source: WSJ)

Eight months ago, in the worst moments of the Great Panic of ’08, then-Treasury Secretary Henry Paulson persuaded Congress to provide $700 billion for what he said was the crucial task of buying lousy real-estate loans and securities, the “toxic assets,” from the nation’s banks.

Four months ago, Treasury Secretary Timothy Geithner proposed to leverage some of that money with private money to buy as much as $1 trillion in what he delicately dubbed “legacy assets” from the banks to repair their balance sheets and get them lending again.

The government has yet to buy any of these assets. Instead, it bought about $200 billion worth of shares in the banks, and this week it allowed 10 big banks to repay $68.3 billion of that taxpayer money. The key: Big banks have raised about $65 billion in private capital in the past several weeks, an accomplishment that seemed unimaginable just a few months ago.

So is it no longer necessary for the government to get toxic assets off banks’ books to get credit flowing again? Is bolstering banks’ capital a substitute for ridding them of smelly loans and securities?

We’re about to find out. Until this historic episode, the internationally accepted recipe for fixing a banking crisis had three ingredients: take bad assets off bank books, temporarily guarantee their debts and deposits, recapitalize the banks. The notion was that removing toxic assets usually was necessary before a bank could attract new capital or a buyer and get on with the business of making loans.

Banks need capital to absorb losses when borrowers don’t repay their loans. If a bank’s capital cushion is large enough, it can absorb all the losses it faces and remain solvent. (Say a bank is carrying a loan at 80 cents on the dollar, but it’s really worth 50 cents. Investors don’t want to lend that bank money or, if they do, they charge a lot. That makes it hard for the bank to lend readily. With a fat enough capital cushion, the bank’s solvency is assured even if it has to mark the loan down to 50 cents.)

The very stressful stress tests conducted by the regulators were intended to calibrate how much capital the big banks needed in a terrible, though not worst-case, economy. Arithmetically, if banks raise enough capital, then there’s no need for the government to buy the toxic assets. And we all live happily ever after.

Perhaps. But ridding toxic assets accomplishes two other things. First, it removes any doubt about looming undisclosed losses. As long as toxic assets remain on bank books, there’s uncertainty about whether they’ve been marked down enough to reflect reality. If they’re gone, it doesn’t matter.

Second, it removes a huge distraction for management, which may be prerequisite to focusing on making new loans, the objective of all these efforts.

Michael Bleier, a banking lawyer at Reed Smith in Pittsburgh who spent 14 years as general counsel at Mellon Bank, says this is a big deal. In 1988, Mellon created a “bad bank” to hold and sell $1.4 billion worth of bad real-estate and energy loans that were then worth 47 cents on the dollar. “One of the key reasons we did this was that management’s time and attention was being taken up with questions like: What are you going to do with this stuff?” Mr. Bleier said. “By not getting rid of the assets, management attention is somewhat diverted.”

The bad bank was a success at its sole mission: It sold the assets and closed its doors in 1995. And the good bank, Mellon, was healthy enough to be making acquisitions in late 1989 (and was later acquired by Bank of New York.)

Mr. Geithner’s Public Private Investment Program to buy toxic loans is going nowhere; the PPIP to buy securities may yet materialize. If markets and banks deem all this no longer necessary because the financial system has pulled back from the abyss and banks have raised more capital than expected, that’s good.

That’s not the only possible explanation. Bankers always will be reluctant to sell if they have to mark down loans; they’d rather wait and hope for better times. But the Treasury offered investors a sweet deal here — and found few takers amid much anxiety about whether participating would subject investors to congressional scrutiny and limits on executive pay. If the lack of appetite for these deals instead reflects Wall Street worries about the political risk of doing business with the U.S. government, that’s not so good.

At a Senate hearing this week, Mr. Geithner said lack of interest in toxic-asset sales reflects elements of both explanations. And he isn’t ready to abandon the effort. If the economy takes a bad turn, or attitudes toward banks change — particularly toward banks that weren’t deemed healthy enough to give back taxpayer capital — a mechanism for removing toxic assets may yet prove essential to reaching a happy ending.