Will Rescue Bill Rescue Us?

admin1 · Site Admin Joined: 02 Feb 2005 Posts: 7

On Friday, President Bush signed into law the Paulson plan, which aims to jumpstart a financial system that has virtually been shut down by the deepening mortgage crisis. Although there are some attractive aspects of the plan, Treasury Secretary Henry Paulson bungled its marketing big time.

Paulson introduced his proposal with an imperious demand: $700 billion with no Congressional oversight! And then he did not discourage the use of the word "bailout" when, if structured properly, the Treasury plan could net the government a nice profit instead of bailing out Wall Street.

But all of this is water over the dam. Now that Congress has approved the plan, here's my take on the good and the bad.

Bailout

The Paulson plan need not become a wholesale bailout of troubled financial institutions. It is possible that the plan can be a "win" for both taxpayers and banks. One of the central tenets of economics is that a trade often involves gains to both parties and this is no exception.

The collapse of the housing market has sharply lowered the price of real estate, so many of the mortgages and securities issued against homes are now "under water," or worth less than the value of the house. If a lender wrote a $300,000 mortgage on a house that is now worth only $150,000, the "intrinsic" or underlying value of the loan is now 50 cents on the dollar. Although some states allow the lender to go after the borrower's non-real estate assets to satisfy the mortgage payments, in practice lenders take possession of the home, even if it is worth less than the loan value.

But in these stressed times, the lot for mortgage lenders is even worse. Because of the current illiquidity of the mortgage-backed security markets and the confusion of ownership rights of some of these complex securities, investors are willing to pay only 30 cents on the dollar or less for an asset with a 50 cent intrinsic value. It is in this situation where the government has an opportunity to improve the lot of the buyer and seller. The Treasury has the ability to hold these assets until the mortgage is restructured in order to realize the intrinsic value of the loan.

This does not mean a recovery of 100 cents on the dollar, but, if the government can buy the loan for 40 cents, it can still receive a good return on the investment if prices eventually rise to only 50 cents. In the meantime, the financial institution has swapped a distressed asset for a highly liquid security. Treasury bonds can count towards the capital that the bank must have in order to start lending again.

The best way for the government to sell Treasury bonds in exchange for the banks' distressed assets is to run a "reverse auction." The Treasury announces that it is willing to buy a certain amount of mortgage-related securities and asks financial institutions to submit a sealed bid for the price and...[read more]