Does Treasury’s $700b Bailout Proposal Help Companies or Taxpayers?


On Friday afternoon, Treasury Secretary Henry Paulson briefly outlined his proposal for helping banks move through the credit crisis that began in summer 2007 and flared up significantly in the last 60 days. The proposal says that all Americans are at risk:

The financial security of all Americans – their retirement savings, their home values, their ability to borrow for college, and the opportunities for more and higher-paying jobs – depends on our ability to restore our financial institutions to a sound footing.

Paulson discusses how case-by-case actions—like the Fed-assisted Bear Stearns takeover by JP Morgan Chase; Treasury’s Fannie/Freddie takeover and $85b line of credit to AIG; and Friday morning’s announcement that the SEC would ban short selling and Treasury would use $50 billion to back money market mutual funds—are not enough to solve the credit crunch we’re facing.

Despite these steps, more is needed. We must now take further, decisive action to fundamentally and comprehensively address the root cause of our financial system’s stresses.

He said “lax lending practices” led to this crisis which has put 5 million homeowners into delinquency or foreclosure, and he also talked about the domino effect: lenders who made the mortgages, securitizers who bought the mortgages to package and sell as bonds, speculators who bought credit default insurance on these bonds, and all other parties throughout the financial system are now caught up in the problem. As such, their balance sheets are locked up with unmarketable debt they can’t move in order to make new loans. Perhaps most problematic is the credit default insurance (or ‘credit default swaps’) which are completely unregulated so nobody knows how big this problem is:

The inability to determine their worth has fostered uncertainty about mortgage assets, and even about the financial condition of the institutions that own them.

The program that Paulson has proposed asks for the Treasury to be able to purchase up to $700 billion in illiquid assets from financial institutions so they’re free to make new “productive loans” with proper and transparent underwriting standards to businesses and consumers. For now the timing says only that Treasury would report back to Congress within 3 months of its first mortgage-related asset purchase, and then report semi-annually afterward. An important point of the plan is that, over time, it can be well above $700b:

The Secretary’s authority to purchase mortgage-related assets under this Act shall be limited to $700,000,000,000 outstanding at any one time.

Treasury definition of ‘mortgage-related assets’: The term “mortgage-related assets” means residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before September 17, 2008.

Treasury/Fed Turning Into Hedge Funds/Subprime Lenders Using Taxpayer Dollars: This bad debt repurchase plan plus the AIG loan and Fannie/Freddie takeover make Treasury and Fed into some hybrid of hedge funds and subprime lenders that use taxpayer dollars to unwind the excesses of an under-regulated financial sector. Taxpayers have good reason to be concerned overall, but as we discussed, the AIG bailout loan might be OK for taxpayers in the long run given the terms of the AIG deal (as we understand it).

As for the debt repurchase plan, it’s current iteration doesn’t seem to have any ultimate benefit for taxpayer dollars invested because the definition of mortgage-related assets above is so broad, there’s no direct formula to determine which assets will be purchased and for how much.

For basic mortgage backed securities, this plan seems reasonable as a way to help credit market liquidity, but there’s still no specific measure for return on taxpayer dollars. When it comes to derivatives, the case for purchasing these assets with taxpayer money becomes very hard to support—especially when Treasury admits they can’t properly assess the condition of financial firms with significant derivative positions. Derivatives are a hedging tool and/or pure speculation tool, and besides some exceptions, there doesn’t seem to be a valid argument to give priority to backing these. Paulson acknowledged the massive commitment of taxpayer dollars, but pointed out that there really is no alternative:

I am convinced that this bold approach will cost American families far less than the alternative – a continuing series of financial institution failures and frozen credit markets unable to fund economic expansion.

He is primarily concerned with the short-term chaos where the dominoes fall as discussed above. But he didn’t yet address how taxpayers would be protected. He did however address long-term regulatory structure:

When we get through this difficult period, which we will, our next task must be to improve the financial regulatory structure so that these past excesses do not recur. This crisis demonstrates in vivid terms that our financial regulatory structure is sub-optimal, duplicative and outdated. I have put forward my ideas for a modernized financial oversight structure that matches our modern economy, and more closely links the regulatory structure to the reasons why we regulate. That is a critical debate for another day.

This is at least a tacit admission that an unregulated derivatives market that is one of the biggest problems, and that the “CFTC Modernization Act” (that squeaked through Congress in December 2000 as an add-on to an existing bill) exempting credit derivatives from regulation has finally come home to roost.

Basis Point of Disclosure: The Basis Point is doing the best we can to keep up with unprecedented changes in the markets and do our best to fact check the items we discuss, but we may not be getting all of this correct. Please chime in with corrections if you see errors. Thanks.

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