Bailout Question Looms: What’s the Real Price?

As details of Treasury's bad-asset-purchasing measures trickle out, observers like Harvard law professor Hal Scott ask what the government will pay...
Marie LeoneSeptember 22, 2008

While the Treasury Department took swift action to stop the bleeding on Wall Street, gaping holes remain in its $700-billion rescue plan to buy illiquid mortgage assets from banks and other financial institutions. The biggest question, Harvard law professor Hal Scott is asking: At what price will the toxic assets be bought?

In general, the bailout “is a very good thing … but I worry about the quality of answers we will get to the questions [that still remain],” Scott told when the plan was first announced on Friday. Still, he says that “if the alternative is Armageddon, we don’t have a choice” about making the plan work.

Scott, who is also the director of the Committee on Capital Markets Regulation, a nonprofit group that has sent its recommendations to the Treasury Department in the past, reckons that the price won’t be too low because the idea behind the bailout is to bolster, not erode, the capital of companies that participate. But he posits that if the institutions receive ninety-five cents on the dollar, the public outcry would be thunderous. “Congress won’t let that happen,” he contends.

In a statement made over the weekend, the Treasury Department noted that the price of assets purchased will be established “through market mechanisms where possible, such as reverse auctions.” Further, the dollar cap will be measured by the purchase price of the assets, and the authority to purchase the sour mortgages will expire two years from the date of enactment.

It remains unclear, however, which organizations will be permitted to take advantage of the bailout. So far, Treasury seems to be focused on banks, saying that participating “financial institutions” must have significant operations in the U.S. to qualify, unless they get special permission from the Treasury Department and the Federal Reserve Board to take part in the program.

During weekend talk shows, Paulson emphasized that the subprime bailout is not an expenditure similar to the cash being spent on the war in Iraq, but rather a “buy and hold” program, in which money would be returned to taxpayers over time when the assets become liquid again. Treasury officials explained that cash received from liquidating the assets, including any interest “will be returned to the Treasury’s general fund for the benefit of American taxpayers.”

Professor Scott was quick to point out that this recent bailout is not similar to the plan devised to rescue the savings and loan industry during the 1980s, when the Resolution Trust Corp. was formed by the government. The RTC’s mandate was to buy up thousands of small, failed banks. In this case, Treasury is not taking over bankrupt companies, but rather removing bad assets from balance sheets of troubled institutions, explains Scott.

On Friday, Paulson said the root of the problem was a lack of regulation that allowed lax and predatory lending practices. As a result, high-risk mortgages — that are now either delinquent or in foreclosure — mounted up on the balance sheets of banks or in the portfolios of companies that purchased mortgage backed securities. When these subprime mortgage homeowners defaulted, hundreds of billions of dollars bad debt “clogged” the system, said Paulson.

In the case of banks, the illiquid assets prevent them operating, because under current regulation, banks and other financial institutions have to meet stringent capital ratio requirements to make sure they have enough of a cash cushion to cover bad debt. If they don’t have the prescribed cushion, banks cannot make new loans.

For corporations exposed to subprime mortgages through securitizations or other financial instruments, such as collateralized debt obligations, the illiquid assets can shift capital ratios enough to put some debt covenants in default, or simply weigh down balance sheets and stifle growth.

Scott is also looking for clarification on whether the Treasury Department considers insurance companies, private equity firms, and hedge funds, as “qualified” financial institutions in terms of participating in the bailout. “And what about Lehman? Is it fair if it can’t sell [its illiquid mortgage assets] to the government?” asks Scott, referring to Lehman Brothers, the venerable investment bank that declared bankruptcy last Monday.

In its statement, Treasury said that to qualify for the bailout program, assets must have been originated or issued on or before September 17, 2008. But no one is saying whether Lehman’s bankruptcy bans it from participating in the program. A week before its Chapter 11 filing, Lehman reported a $5 billion write down for the third quarter, mainly comprised of bad mortgage exposures.

Regardless of the details, Scott believes that the next administration will be saddled with an enormous burden. The Treasury Department and Congress “will have to get buy-in from both presidential candidates, Obama and McCain” for the plan to have any chance of succeeding. If there is no buy-in, “then the market should not believe it will happen.”

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