How Much Will It Cost and Will It Come Soon Enough?

There is no question that the current bailout bill represents an enormous improvement over the original Treasury proposal. Unlike the original proposal, this bill protects the public interest with requirements for disclosure and audit, for reporting to Congress both on procedures and results, and with protections against arbitrage, conflict of interest, and fraud, with provisions requiring the secretary of the treasury to try to minimize foreclosures, to acquire warrants, and with limitations on executive compensation, especially golden parachutes.

In several respects, the language could still be improved. For instance, the "unjust enrichment" provision limiting the price Treasury pays for any troubled asset to the price at which it was acquired has two potential problems. First, it might be construed as permitting Treasury to pay up to the original purchase price of a security, in which case an investor who stocked up on bad securities would pay no price for foolish or mistaken investment choices. Second and more important, it could be construed as permitting an eligible entity to buy up mortgage-backed securities from other entities and to pass them along to the Treasury with neither profit nor loss.

The problem here is, in turn, two-fold: it would appear to permit the Treasury to buy assets indirectly, in effect, from any entity in the world, so long as an eligible entity acted as a middleman. To put it mildly, it may not be the intent of Congress to extend the provisions of this bill to foreign investors, hedge funds and banks, but there appears to be no obstacle to that in the language. And, it would appear to allow other eligible entities to circumvent other provisions, such as the golden parachute restrictions, simply by lining up behind a middleman rather than participating directly in the program. There is an easy fix. Requiring the maximum price paid by the Treasury to be below the documented purchase price by a suitable discount would tend to resolve both of these major issues.

Another area where the language could be strengthened is in the clause relating to preventing foreclosures. Where the Treasury may be in the situation of dealing directly with mortgage lenders, Congress could insist that the discount on the price paid for mortgages be substantially greater, if a lender initiates foreclosure proceedings between the date of enactment and the sale of the mortgage-related securities to the TARP. This would provide a useful incentive for lenders to refrain from initiating foreclosure proceedings in advance of the sale of mortgage instruments to the TARP.

On executive compensation, the bill takes care of one major danger-- golden parachutes -- by simply prohibiting them. It does less to regulate ordinary executive pay. I am sympathetic to the urge to strengthen this provision if it is politically possible; for example to tie bonuses strictly to long-term performance, and to ban back-dated options. Strict limits on base salary in addition are an option, but it must be recognized that the existing top leadership in the financial sector would then, for the most part, simply leave their jobs.

Further, anti-fraud provisions requiring that firms investigate fraud and make criminal referrals (or SARS) as appropriate, and agree to assist DOJ in the investigation and prosecution of frauds, could be implemented by regulation -- as is already required of insured institutions.

The question now is could the purposes of this bill be met with a smaller appropriation. In my view, the best way to answer that question is to ask: What problem does $700 billion solve? The answer to that is, we do not really know. On the face of it, the exposure to bad mortgage-backed securities is considerably larger; the purchase plan in the bill would inevitably bail out some inessential as well as essential investors and institutions, thus wasting a fraction of the resources; and we do not know the full extent to which banks need new capitalization in order to remain solvent. The reasonable presumption, therefore, is that TARP would buy time; one hears estimates that the authority would be used at a rate of $50 billion a month, though the basis for that estimate is not clear. A smaller appropriation would buy less time.

How much time is needed? There is in my view very little prospect that economic recovery will restore housing prices and personal incomes within a reasonable time -- that is, before the $700 billion runs out. Therefore, it seems to me unlikely that this issue will finish here; more will be needed at a later date. However, on the assumption that one can trust and monitor the actions of the Treasury to assure that it carries out its mandate in good faith, there is an argument for appropriating the full sum now: It will help ensure that the system will hold into next year. A smaller appropriation increases the risk of a major crisis in the relatively near term. By how much and when? No one can say.

If one does not trust the Treasury to act in good faith and in compliance with the spirit and letter of the monitoring and enforcement provisions, then of course there is no case for this bill.

Many are concerned with the fiscal implications of this bill, so let me turn to that question. Despite the common use of language, the capital cost of this bill does not involve "taxpayer dollars." It authorizes a financial transaction, exchanging good debt (U.S. Treasury bills and bonds) for bad debt (the "troubled assets"). Many of those troubled assets will continue to earn income for some time, perhaps a long time. The U.S. Treasury commits itself to paying the interest on the debts it issues. The net fiscal cost -- which is also the net fiscal stimulus -- of this bill is the difference between those two revenue streams. Given the very low rate of interest presently prevailing on Treasury bills, this is likely to be somewhere between $20 billion per year and zero from the beginning, even if the Treasury were to issue all $700 billion in new debt at once. It is a mistake, in short, to count the capital cost as a "cost to the taxpayer." This is not the war in Iraq.

In the longer run, of course the Treasury will incur capital losses on the assets it acquires. The entire purpose of the bill is to overpay for bad assets, so as to give financial institutions a chance to recapitalize themselves. The proposal to recoup that capital at a later date through a fee on the same institutions strikes me as being somewhat defeating of the very purpose of the bill. If it is desirable to raise tax revenues to cover the running cost, a turnover tax in the stock market is an attractive alternative -- if it could be passed.

Next, let me ask: Could one, in principle, write a still better bill? I believe that the answer is clearly, yes. I expressed that view in an op-ed in The Washington Post last Thursday. My proposal would be to eliminate the current $100K cap on Federal Deposit Insurance, to use a direct appropriation to purchase preferred shares in viable banks requiring recapitalization, and to use the bridge bank facility to deal with banks that are actually insolvent. The FDIC provision would tend to prevent the major danger of panic-driven bank runs, which already figured in the speed of the collapse of WaMu last week. Full FDIC insurance would also draw funds into banks from money market funds (unless they too were insured and regulated), eliminate the need for interbank borrowing, and generally stabilize the system.

I have since learned that the authority to extend FDIC guarantees to all general creditors of the banking system already lies with the chair of the FDIC, and this raises an important tactical possibility, that members could insist that she exercise that authority as a condition of support for the bill. This, alongside certain other measures dealing with short-selling and mark-to-market accounting, could bring much if not all of the banking crisis rapidly under control. At that point, bank examiners could assess the loan-value and solvency questions in an orderly way.

Whatever happens, if my analysis is correct, even if the bill is passed the issues will not go away. The $700 billion will permit parts of the banking system to be reorganized. I doubt it will cure an underlying problem of illiquid securities many times larger than that. I believe that as banking consolidation proceeds, alongside the decline and fall of the "shadow banking system," the fact that deposit insurance, regulation, disposition of bad assets and enforcement are the sensible way forward will become increasingly apparent. In short, I would do these things now if I could. But if they are not done now, they will still have to be done later, even if this bill is passed.

A larger issue concerns the relationship of this bill to the overlying economic situation. Will this bill "unblock the channels of credit" and restore the economy to normal? I would answer in two parts. First, if it is the case that runs on money market funds are threatening the liquidity of the corporate financial system, urgent measures including the Treasury's insurance facility should be put in place to prevent that. Here the TARP plays a somewhat tangential role. Think of it as a slush fund with which Treasury can recapitalize banks as needed, for a time. But even though it is tangential, it may be a useful and perhaps necessary part of a program to prevent, or defer, a disaster.

Second, neither this program nor my FDIC proposal will prove sufficient to restore economic growth and high employment. For that purpose, resolution of the underlying housing problem, of the revenue problem of state and local governments, and of the wealth and income problems of retirees and other asset-dependent parts of the population are all essential. Those measures lie ahead; they will not be part of this bill.

However, the fate of this program will depend on the willingness of Congress to solve these problems at a later date. If the economy is allowed to stagnate, foreclosures will multiply and the financial system will continue to implode. Only a comprehensive approach to deal with the deeper issues of jobs, wages, pensions, and housing can generate the income streams necessary to make the mortgage burdens sustainable over time.

In short, as I said at the beginning, the bill is a vast improvement over the original Treasury proposal. Given the choice between approving or defeating the bill as it stands, I would urge supporting the bill. I do so without illusions. There need be no pretense that it will solve our underlying financial and economic problems. It will not. The purpose, in my view, is to get the financial system and the economy through the year, and into the hands of the next administration. That is a limited purpose, but a legitimate purpose. And it may be the most that can be accomplished for the time being.

This piece is adapted from remarks made before the Democratic Congressional Caucus.

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