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Thoughts on the Bailout Plan

posted by Adam Levitin

[Revised 9.21.08 at 1:40 pm9.20.08 at 4:15pm]

The Treasury's bailout plan is out. There's really not much to it: under the plan, the Treasury would be authorized to purchase up to $700 billion in mortgage-related assets from US headquartered financial institutions. To put it in even simpler terms, Paulson has asked for a $700BN mortgage slush fund, no strings attached. Given where we are, this might be about the only thing possible. But there are still lots of questions raised by the Treasury's very terse proposal. Not least of them are:

1. How much toxic MBS paper is out there? Does $700BN cover it all? Does anyone know? I'm not real confident about this. Presumably $700BN doesn't cover everything at face value, but the Treasury isn't going to pay anywhere close to 100 cents on the dollar. So what is the average discount on MBS that $700BN would cover?

2. Will $700BN cover enough to stabilize the markets? We've already seen two (or three) situations in which the Powell Doctrine of overwhelming force has failed when applied to financial markets: first with Paulson's Fannie and Freddie bazooka, second with Geithner's $85BN purchase of an insurance company with $10BN market cap, and third with the Fed and other central banks' opening the floodgates to support the market on Thursday and Friday. Of course one could well argue that but for these displays of shock and awe, things would be much worse. Still, we should be very sure that this is the full price to taxpayers for the bailout before authorizing one; if Treasury comes back in three months and requests another $700BN, it'll be hard to refuse, but an upfront deal of $1.4 trillion might be a harder sell. We don't want to find out this is a really a blank check.

3. Will the Treasury purchase everyone's bad debts or only specific institutions? The proposal makes it discretionary. Will only commercial banks and i-banks be bailed out? Mutual funds? Hedge funds too? If it isn't everybody (and question 4, on mechanics, relates to this), then who will it be? Certain classes of institutions? Or certain size institutions? The discretion that the proposed legislation would give to Treasury could create serious fairness issues.

4. How is the Treasury going to actually do the bailout? The effectiveness of a bailout depends on its mechanics, and it doesn't appear that Treasury has decided on this. I can think of three possibilities:

(a) Offer X cents on the dollar for particular enumerated classes of MBS/CDOs, etc. Hold the offer open for a limited window, and no bailout late for anyone who doesn't cash in now. Of course, I doubt that Treasury would stick to that deal if a major firm were threatened down the road. The good thing about operating this way is it would be simple and fast. The bad part would be adverse selection (only paper worth less than X cents/dollar would be sold). A limited time window for the offer and the threat of litigation against directors who didn't take the deal and then found their institutions going bust might help overcome it, but that depends on the credibility of the "no more bailouts" threat, which just isn't that credible.

(b) Negotiate individual deals with each financial institution. If the Treasury goes institution by institution, are larger and more important institutions going to get better deals than the ones Treasury isn't so concerned about? What sort of transparency will there be in this process?

(c) Negotiate deals with each institution for each asset type or each individual asset? That seems like it would have huge transaction costs and take too long to accomplish to help out liquidity pressed institutions. If the Treasury does go asset-by-asset, are they really capable of marking them to market? If the financial institutions themselves can't figure out the valuation, how can Treasury? What a messy process this will be and what a feeding frenzy for deal attorneys.

[Added 9.21.08 at 1:40pm. Some indication as to how this bailout will be done may be found in the provision that would authorize the Treasury to appoint financial institutions as its agents. That points to methods (b) or (c), not (a). It also raises some serious questions about the possibility of self-dealing, churning, and other conflicts of interest, especially as there is no judicial review possible for any of this. The bailout has a bit of a look of a no-bid contract. Who do you think will get a piece of the deal action? Goldman Sachs? (In fairness, it's not like there are that many big i-banks left standing.) I would feel a lot better about the bailout package if it were to be run out of an independent agency (RTC-style) and were subject to more careful oversight. It's quite easy for a few billion to be wasted here or there when playing with $700BN no accountability, not even a reelection campaign.]

5. Does getting the toxic assets off banks' balance sheets actually solve things? If the Treasury takes them for a lower price than the banks have been carrying them, the banks' assets fall, which could itself cause trouble. By buying the MBS, the Treasury is essentially creating a market for them now, allowing assets to be marked to market more accurately. Our current situation involves tremendous uncertainty about financial institutions' solvency and hence credit risk. But ending that uncertainty might actually show that some institutions are in worse shape than anyone suspected. That could create other crises (but hopefully more easily contained ones). Of course, since the Treasury is playing with taxpayer money (and this administration is lame duck anyhow), the Treasury might not drive as hard of a deal as someone playing with its own money might.

6. What about the consumers? There's nothing in the bailout to help consumers, just to help banks.

Even if the Treasury purchases a boatload of MBS, it isn't clear that will stop foreclosures. To modify the terms of an MBS, a supermajority of the interests in a particular trust are needed. The Treasury might be able to scoop up the B and C tranches, but if the A tranches are in the money still, there might not be a deal. Even if Treasury can get to the underlying mortgages by purchasing the MBS, it will take quite a while to sort through everything and put the brakes on the foreclosure machine.

7. Isn't there a price tag for the financial institutions? Bailouts shouldn't be free. Any bailout bill should be passed with an explicit price tag: bailout now for serious regulatory reform later (I would suggest that should start with a return to Glass-Steagall, a requirement that OTC products to be exchange traded, and a move from disclosure-based consumer protection to regulation that focuses on the substantive terms of consumer debts.)

I don't know how one writes in a provision that any financial institution that accepts the bailout won't oppose future regulation, but the idea of banks getting bailed out now and then using taxpayer dollars to lobby against regulatory reform is pretty galling.

Treasury is making the case that time is of the essence, but Congress should get answers to these questions (and a host of others) before authorizing $700BN (and maybe more down the road).

Comments

I have to confess that I only have a tenuous grasp of all of the nuances involved with the credit crisis (and I'm sure MOST Americans are in the same boat with me)... but I DO find it galling that the Feds plan ONLY addresses assistance for the financial institutions, and includes no provisions for any of the $700B to assist average Americans in danger of losing their homes.

Correct me if I'm wrong (which I'm sure I am), but if a large portion of the people who are defaulting on their loans could suddenly afford to make their payments, wouldn't a lot of this crisis disappear? And wouldn't it be great to help keep as many people as possible in their homes?

The draft that is reportedly in play:

Section 1. Short Title.

This Act may be cited as ____________________.

Sec. 2. Purchases of Mortgage-Related Assets.

(a) Authority to Purchase.–The Secretary is authorized to purchase, and to make and fund commitments to purchase, on such terms and conditions as determined by the Secretary, mortgage-related assets from any financial institution having its headquarters in the United States.

(b) Necessary Actions.–The Secretary is authorized to take such actions as the Secretary deems necessary to carry out the authorities in this Act, including, without limitation:

(1) appointing such employees as may be required to carry out the authorities in this Act and defining their duties;

(2) entering into contracts, including contracts for services authorized by section 3109 of title 5, United States Code, without regard to any other provision of law regarding public contracts;

(3) designating financial institutions as financial agents of the Government, and they shall perform all such reasonable duties related to this Act as financial agents of the Government as may be required of them;

(4) establishing vehicles that are authorized, subject to supervision by the Secretary, to purchase mortgage-related assets and issue obligations; and

(5) issuing such regulations and other guidance as may be necessary or appropriate to define terms or carry out the authorities of this Act.

Sec. 3. Considerations.

In exercising the authorities granted in this Act, the Secretary shall take into consideration means for–

(1) providing stability or preventing disruption to the financial markets or banking system; and

(2) protecting the taxpayer.

Sec. 4. Reports to Congress.

Within three months of the first exercise of the authority granted in section 2(a), and semiannually thereafter, the Secretary shall report to the Committees on the Budget, Financial Services, and Ways and Means of the House of Representatives and the Committees on the Budget, Finance, and Banking, Housing, and Urban Affairs of the Senate with respect to the authorities exercised under this Act and the considerations required by section 3.

Sec. 5. Rights; Management; Sale of Mortgage-Related Assets.

(a) Exercise of Rights.–The Secretary may, at any time, exercise any rights received in connection with mortgage-related assets purchased under this Act.

(b) Management of Mortgage-Related Assets.–The Secretary shall have authority to manage mortgage-related assets purchased under this Act, including revenues and portfolio risks therefrom.

(c) Sale of Mortgage-Related Assets.–The Secretary may, at any time, upon terms and conditions and at prices determined by the Secretary, sell, or enter into securities loans, repurchase transactions or other financial transactions in regard to, any mortgage-related asset purchased under this Act.

(d) Application of Sunset to Mortgage-Related Assets.–The authority of the Secretary to hold any mortgage-related asset purchased under this Act before the termination date in section 9, or to purchase or fund the purchase of a mortgage-related asset under a commitment entered into before the termination date in section 9, is not subject to the provisions of section 9.

Sec. 6. Maximum Amount of Authorized Purchases.

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

Sec. 7. Funding.

For the purpose of the authorities granted in this Act, and for the costs of administering those authorities, the Secretary may use the proceeds of the sale of any securities issued under chapter 31 of title 31, United States Code, and the purposes for which securities may be issued under chapter 31 of title 31, United States Code, are extended to include actions authorized by this Act, including the payment of administrative expenses. Any funds expended for actions authorized by this Act, including the payment of administrative expenses, shall be deemed appropriated at the time of such expenditure.

Sec. 8. Review.

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

Sec. 9. Termination of Authority.

The authorities under this Act, with the exception of authorities granted in sections 2(b)(5), 5 and 7, shall terminate two years from the date of enactment of this Act.

Sec. 10. Increase in Statutory Limit on the Public Debt.

Subsection (b) of section 3101 of title 31, United States Code, is amended by striking out the dollar limitation contained in such subsection and inserting in lieu thereof $11,315,000,000,000.

Sec. 11. Credit Reform.

The costs of purchases of mortgage-related assets made under section 2(a) of this Act shall be determined as provided under the Federal Credit Reform Act of 1990, as applicable.

Sec. 12. Definitions.

For purposes of this section, the following definitions shall apply:

(1) 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.

(2) Secretary.–The term “Secretary” means the Secretary of the Treasury.

(3) United States.–The term “United States” means the States, territories, and possessions of the United States and the District of Columbia.

Non-reviewable by any court. Wow.

The debt ceiling goes up to $11.315 Trillion.

On the day George Bush took office, January 20, 2001, the national debt was $5,727 Trillion.

http://www.treasurydirect.gov/NP/BPDLogin?application=np

The U.S. consumer isn't the only one that has a little out of whack on the spending versus income ratio.

That should be $5.727 Trillion.

Also: "Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion...."

I'm assuming that means no Congressional oversight. If so, Wow! This combined with no court review means the executive branch is like king or something.

Is this right? Can they really do this?

The unfettered discretion given the Treasury secretary is mind boggling, especially given the total absence of standards by which Treasury gets to spend the 700 billion. Only a Congress cowed by fear would sign such a blank check.

The problem, at least as it is being sold to the media, is lack of credit in the market. But this is the wrong solution to that problem. The government could easily make money available to worthy borrowers without buying distressed mortgage backed securities.

In short, this is the biggest taxpayer scam of all time. The question is will anybody in the Congress have the guts to say so and stop this nonsense.

How can Congress give an unelected official such power ? Is this not unconstituional?

As with all such things, the devil is in the details.

I don't see anything in the draft legislation that prevents even more servicing abuses on these loans.

But the ultimate question is who is going to establish the cost basis - the servicer? You can't trust them to even calculate a payoff, let alone assign a book value. Many of these really toxic loans they purchased for pennies on the dollar already. They'll pad loan balances up the yazoo and sell them at enormously-inflated prices rather than the intended discount.

I think the secretary is far too trusting.

http://news.yahoo.com/s/politico/20080921/pl_politico/13689

Many economists skeptical of bailout

Avi Zenilman
Sun Sep 21, 8:58 AM ET

Many of the same economists and opinion-makers who'd provided a bipartisan sheen of consensus to Treasury Secretary Henry Paulson's previous moves have quickly begun casting doubts on the wisdom of a policy that would allow Treasury to purchase without oversight hundreds of billions of dollars of difficult-to-price assets from financial institutions.

Under the proposal, Paulson would not have to report to Congress until December, and the only safeguard for taxpayers was a provision that the “Secretary shall take into consideration means for — (1) providing stability or preventing disruption to the financial markets or banking system; and (2) protecting the taxpayer.”


An interesting alternative way to do a bailout:

http://firedoglake.com/2008/09/19/how-to-bail-out-ordinary-mortgage-holders-and-not-just-banks/

This bailout plan stinks to high heaven. It does look like a "no bid" contract -- the Treasury will buy "toxic" mortgage assets at prices yet to be determined, but apparently at the complete discretion of the Treasury Dept. and quite possibly above current book value and the present value of expected future cash flows. This amounts to a government transfer -- or welfare payment -- to the financial institutions that created this mess. The institutions that have the most toxic mortgages on their balance sheets -- and therefore are probably most responsible for our current mess -- will get the biggest subsidy from Treasury. And there may not be any stipulations placed on financial institutions who receive the Treasury's largesse. For example, if the institutions who sell mortgage assets to the Treasury at inflated prices use the proceeds to delever (i.e. pay down their debts) or to increase dividends, bank credit will not increase. So it is quite possible that financial executives and equity holders will reap benefits from a bailout, but that the non-conforming mortgage market will remain shut and that the availability of credit to the corporate sector will remain extremely constrained. So its a great program to bail out financial executives and their stockholders, but offers no explicit assurance that these benefits will trickle down to Main Street. I suspect Hank Paulson will be rewarded with some cushy job with obscene compensation next January for putting lipstick on a pig and selling it to Congress.

Not sure if this is real, but if true, it would suggest that mortgage modification in bankruptcy is back in play. This is supposedly an e-mail from a member of Congress:

"Henry Waxman has suggested corporate government reforms, including CEO compensation, as the price for this. Some members have publicly suggested allowing modification of mortgages in bankruptcy, and the House Judiciary Committee staff is also very interested in that. That's a real possibility.

We may strip out all the gives to industry in the predatory mortgage lending bill that the House passed last November, which hasn't budged in the Senate, and include that in the bill. There are other ideas on the table but they are going to be tough to work out before next week.

I also find myself drawn to provisions that would serve no useful purpose except to insult the industry, like requiring the CEOs, CFOs and the chair of the board of any entity that sells mortgage related securities to the Treasury Department to certify that they have completed an approved course in credit counseling. That is now required of consumers filing bankruptcy to make sure they feel properly humiliated for being head over heels in debt, although most lost control of their finances because of a serious illness in the family. That would just be petty and childish, and completely in character for me."


http://www.openleft.com/showDiary.do;jsessionid=6C994487A9D89B836DC572DE8CF60263?diaryId=8374

So is this how the Republic dies? Extorted by the criminals on Wall Street?

If we allow this, we end our Constitutional government in favor of corporatism.

I hope that Congress requires that when the government buys in a mortgage at a discount, it offer all of the underlying mortgagors a substantial portion of that discount. While I am strongly opposed to laws that would modify mortgage loans between two private parties in any way, once the mortgage has passed by a voluntary transaction into the hands of the government, and especially when it has done so at a discount, then that discount should be passed back into our scoiety as widely as possible. For example, if the govenment bought an MBS at 50, it should offer each underlying mortgagor a one-year option to restructure its mortgage as a fixed rate 30 year loan for 55% of the outstanding amount. (the extra 5% is to allow for the prospect that some of the mortgages, whether or not restructured,in the pool will default anyway). The interest rate should be re-set at a level that enables the loan to be resold at the govenment's cost, ensuring that taxpayers are not hurt. In this way, all modifications would result from voluntary transactions, and the pain of the lending mistake would rest entirely on the stakeholders of the organizations that made the bad loans in the first place, and not on taxpayers.

MarkT--your onjection to contract modification ("I am strongly opposed to laws that would modify mortgage loans between two private parties in any way") is really an objection to bankruptcy, period, and I want to take polite issue with that objection. Sanctity of contract is important, but contracts aren't suicide pacts. There are circumstances where contract modification benefits a common good, such as the common pool problem that bankruptcy is designed to solve. In these cases, isn't it better to allow contracts to be modified for the collective good under carefully prescribed and predictable rules than in a slapdash reaction to a crisis? Indeed, bankruptcy modification isn't the nullification of contract--bankruptcy is a background term to almost every contact, giving both counterparties an option to file for bankruptcy (which comes, like all options) at a cost. Parties can predict events in bankruptcy; they cannot predict legislative responses to crises that undermine contracts (e.g. Congress's 1933 abrogation of gold clauses). Given that choice, I think it is far better to allow the safety valve of bankruptcy modification than the sudden and panicked reaction to a full blown crisis.

The government won't have the ability to restructure the mortgages even if it buys up a ton of MBS. It's a Humpty-Dumpty problem squared. MBS often place limits on the servicer's ability to modify mortgage loans. Those limits cannot be changed without a supermajority or unanimous consent of the thousands of holders of the MBS from that pool. Those holders are spread out worldwide. The government will have trouble getting 66% or 100%, especially as it can only (per the draft legislation) purchase from US headquartered institutions. Even if the government can reassemble all those pieces fast enough (a huge, huge if), they will also have to reassemble lots of second mortgage securitizations on the same properties and the NIMS securitizations or NIMS insurance contracts. The government simply doesn't have the ability to do this, much less in a meaningful time frame.

Paulson wants $700 Billion, with no oversight, no regulation. I just called all my reps to let them know that I expect COMPLETE TRANSPARENCY - I want to know who is getting how much and when (set up a web site that all taxpayers have access to that reports this data that is searchable). I expect COMPLETE AND THOROUGH REGULATION AND OVERSIGHT (these guys have no morals to guide them, Paulson doesn’t have the mindset of a regulator). I expect PROFIT SHARING FOR TAXPAYERS from any companies bailed out (like A.I.G.) if they are not liquidated and somehow survive and realize profits again. I expect ACCOUNTABILITY AND CONSEQUENCES for those employees and executives, CEOs, CFOs, and ALL COMPANY OFFICERS who committed fraud or broke other laws that got us into this mess.

To find out who your representatives are, go to http://www.votesmart.org , type in your zip code and get a list of reps with contact numbers. Give them a call and let them know ENOUGH!

AMC...Funny! (on the credit counseling part)

Mark T, With all of these recent bailouts, the government is going to own the notes or the biz anyway. Why not get the money flowing fast thru 13s? Maybe investment in those bailed out companies will be a safer bet afterwards and maybe a good deal before.. ??? "Be brave when people are cautious and be cautious when people are brave". (something like that.. W. Buffet)

Why not get the money flowing fast thru 13s?
That a) damages those who hold mortgages that aren't resold to the govt at a discount; b) benefits only those whose financial condition is so bad they file; and c) fails to provide relief for a broader cross-section of America i.e., those who don't go bankrupt. Finally, without a wholesale revision of the means test and the monthly income / expense waterfall, shrinking mortgage payments just increases the money available for credit card service, so you are just moving the debtor's future payments from one lender's pocket to another. Adam L, I think, overstates the difficulties both of holding enough MBS to amend servicing and the dual mortgage problem.

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