Monday, October 6, 2008

Dow Down 10,000 - What's going on?

Matthew Benjamin of Bloomberg writes -- Legislation that the U.S. Congress passed yesterday to stabilize financial markets would give the Treasury almost complete discretion to buy $700 billion of mortgage-backed securities and other troubled assets obstructing lending.

To protect taxpayers and keep Wall Street executives from benefiting, provisions were added that make it easier for the government to profit from the plan or recoup losses, limit executive compensation at participating companies, and establish oversight of the plan.

Following are some questions taxpayers might have about the plan and answers to them:

Will the program keep the U.S. out of recession?

Many economists think a recession is likely later this year with or without the bill. "We're going into a downturn now,'' said Mark Gertler, a New York University economist who has collaborated on research with Fed chief Ben S. Bernanke. "The hope is that the bailout package will moderate the recession.''

Is this a bailout?

Bailouts usually refer to government cash infusions into individual companies. The plan passed yesterday is broad-based, and lawmakers expect many companies to participate. Like a bailout, however, the government may end up with equity stakes in private companies in return for its money.

Why was it necessary for Congress to act so quickly?

Banks basically stopped lending to each other two weeks ago, as shown by a spike in inter-bank lending rates. If that continues, the supply of credit to families and businesses may be choked off, sending the economy into a tailspin. In addition, Congress is set to adjourn, and the presidential election is five weeks away.

Will the plan work?

Many economists think it will help avert an even worse crisis in financial markets and perhaps ameliorate the economic downturn.

"It's a $700 billion band-aid, but band-aids can make you feel better and can hold things together for a while,'' said Simon Johnson, former chief economist at the International Monetary Fund and now a senior fellow at the Peterson Institute for International Economics. By paying better-than-market value for toxic assets held by banks, the government could relieve a crisis of confidence in the financial system, he said.

How long will it be in place?

The authority to purchase troubled assets expires on Dec. 31, 2009, but the Treasury secretary could ask Congress to extend it until late-2010.

How will it be funded?

The Treasury will fund the program by borrowing money. The legislation will increase the government's debt limit to more than $11.3 trillion from $10.6 trillion now, giving the Treasury the ability to borrow enough to fund it.

How will it affect my taxes?

That depends on what the next president does. The initial borrowing of funds for the program will add some $2,300 in government debt for every American. Yet the Treasury will get assets for its money, many of which may increase in value as the housing market and economy improve.
"Much of the $700 billion is expected to be repaid, and there could even be a profit made by taxpayers,'' said Alex Brill, an economic consultant at Washington law firm Buchanan Ingersoll & Rooney and a former policy director for the House Ways and Means Committee.

What kind of assets can the Treasury buy?

Mortgage-related securities are the primary target, ranging from simple mortgages to complex instruments, called collateralized debt obligations, which are bonds backed by pools of mortgages. The bill gives the Treasury secretary the ability to buy, hold and sell "troubled assets'' of any kind. That could include auto and student loans.

Who owns these assets now?

Primarily banks, ranging from Wall Street investment firms to regional banks to small community thrifts.

Is the program voluntary?

Completely. No company will be forced to participate.

How will the insurance provision work?

As an alternative to purchasing troubled assets, the bill directs the Treasury to create an insurance program to guarantee assets and collect premiums from financial institutions to fund it.

Can foreign firms participate in the rescue plan?

Yes. The Treasury can purchase troubled assets from foreign- based institutions.

How will the government make sure it gets these assets at good prices?

The Treasury and the sellers of assets will negotiate the prices paid. Bernanke told lawmakers last month that the Treasury would likely make its purchases at prices above their current market, or "fire-sale'' values, while still seeking some haircuts from face value to shield taxpayers. In addition to straight purchases, the Treasury may use auctions and reverse auctions to set prices.

Will taxpayers lose or make money on this deal?

The assets the Treasury purchases could increase in value, allowing the government to sell them later at a profit. In addition, in return for buying the impaired investments, the Treasury will receive warrants, or contracts allowing it to purchase shares in participating companies at a preset price. If those companies' stocks rise, taxpayers could benefit.

The non-partisan Congressional Budget Office estimated the net cost of the plan will be "substantially less than $700 billion but is more likely than not to be greater than zero.''

If, in five years, taxpayers have lost money, the president will have to submit legislation -- most likely some kind of fee on financial institutions -- to recoup losses.

What happens to shareholders of the participating banks?

They'll benefit immediately if the plan succeeds in preventing sell-offs of bank stocks. In the longer term, if the warrants the Treasury receives are converted to equity, shareholders' stakes will be diluted.

How will the rescue affect executive salaries on Wall Street?

Companies that sell troubled assets to the Treasury won't be able to pay golden-parachute severances while participating in the program.

What will the program do for people in danger of defaulting on a mortgage?

The bill contains vague language encouraging the Treasury to implement plans to help endangered homeowners. Many mortgages, through the securitization process, were broken up into pieces and sold off, making it difficult for lenders to alter them so homeowners can afford rising payments.

"This bill does little to remove the existing obstacles that have made it all but impossible over the past year for the housing industry to help enough people avert foreclosure,'' said Kathleen Day, a spokeswoman for the Center for Responsible Lending in Washington.

How and when will we know if it's working?

The immediate goal is to unfreeze credit markets and restore confidence. A drop in inter-bank lending rates and a rise in the stock market, might indicate the legislation is having a positive short-term effect.

Who will monitor how the money is spent?

The Treasury must consult with the Federal Reserve, Federal Deposit Insurance Corp. and other agencies. There will also be an oversight board consisting of the Fed chairman, Treasury secretary, chairman of the Securities and Exchange Commission and other officials. Treasury Secretary Henry Paulson must submit a report to Congress after each additional $50 billion is spent.

The bill also creates an inspector general, appointed by the president, to oversee the program, and a congressional oversight panel.

"It will be closely watched, but it's a tremendous amount of money, so it ought to be,'' said Doug Elmendorf, a former economist at the Fed and Treasury.

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