As Congressional staffers met with Treasury and Fed officials over the weekend to begin working out the details of the proposed plan for the government to ease the strains on the banking system by buying up toxic mortgage-related assets that are behind the credit crunch, a few more details emerged. According to a three page outline of the plan prepared by the Treasury, they would like authorization to buy up $700 billion in assets; that’s on top of the roughly $200 billion that could be spent shoring up Fannie and Freddie and the $85 billion for AIG. All of which raises huge questions about how the facility will be structured, who will benefit, and what the implications are for the incoming Adminstration. The only certainty? Two months ago, in a story examining why neither of the two candidates’ economic plans add up, we wrote about the severe budgetary and political constraints that either McCain or Obama will face come January; now, those constraints will be far worse. With a budget deficit that looks like it could surpass $1 trillion next year, whichever of the two is elected will face an even tougher time funding his spending and tax cut plans. The enormous spending required for the bailouts will force each to confront tough questions about which of his priorities can still be funded, and which will have to fall by the wayside. Big spending on new health care, or big new tax cuts, are likely to go first.
There are plenty of other more short-term questions about the bailout that Congress, the Administration, and the candidates will have to face in the coming week, too. Among the key issues:
1) Just which financial institutions will be included? The Treasury outline says it will apply to US-based financial institutions. That will include commercial banks and investment banks. But what about hedge funds, insurers or others? For now, they don't appear to be in on the game, though they hold plenty of such assets as well.
2) How will US based subsidiaries of such foreign firms as HSBC or Barclays be treated? Can the government get away with bailing out only US institutions and not the many foreign holders of such assets? The Treasury first said that only US headquartered institutions would be included, then later appeared to soften that by saying that such subsidiaries may also be considered. Excluding foreign holders altogether could cause an uproar abroad -- and raise further doubts among foreign investors about the soundness of investing in US assets over the long term.
3) Just what assets will be included? The language is vague now; purposely so, in order to maximize the Treasury's flexibility. The plan speaks of the ability to purchase "mortgage-related assets". Will that be limited to mortgage-backed securities only? What about the complex collateralized debt instruments and other derivatives that have been created on top of those securities? Or the huge and staggering market for credit default swaps?
4) How much will the government pay for the assets? This is a huge, huge question, and will ultimately determine how much the government is on the hook for, and what the potential is to recover some of the losses as the market recovers. Many banks still have these assets valued on their books well over what they are worth; Merrill sold a chunk of mortgage-backed securities around a month ago for about 22 cents on the dollar in an attempt to save itself. So is that a fair price for the government to pay? The less it pays, the lower the cost to taxpayers, and the greater the potential upside as the market recovers. But the less the government pays, the smaller will be the impact in recapitalizing the banks' weakened balance sheets. They obviously will try to get as much as they can for the toxic debt. So there are big questions around how the government will decide how much to pay -- Treasury now is talking about some form of an auction in which it will bid at a given price and see who will sell -- and what price they'll ultimately have to cough up. 5) Will the bailout be limited just to the mortgage-backed assets on the financial institutions' balance sheets? Democrats in Congress, along with presidential contender Barack Obama, have already complained that the moves will help Wall Streeet but do little to help struggling homeowners facing foreclosure directly. They'd like to include measures that will lead to more help in refinancing or reworking homeowners' mortgages, as well as a broader stimulus for the economy. This will be one of the biggest fights this coming week, as Treasury attempts to hold off those broader measures.
6) What else might be thrown into the pot? Again, some Democrats argue that a long-stalled bill that would allow judges in bankruptcy court to readjust the value of a mortgage must be included. Currently, even if a homeowner struggling under a mortgage he or she can't pay files for bankruptcy, the amount of the debt can't be reduced by the court. Democrats think that should be allowed, but the financial services industry has fought it for months. Democrats will try and include the provision in the bill. They may also try to include restrictions on the pay of executives at the institutions that accept the government bailout, an idea being floated by Barney Frank. With Republican contender John McCain taking on an increasingly populist tone and raging against excessive executive payouts on the stump, it's possible the idea could gain currency. But banking lobbyists will fight that tooth and nail too.
7) Just where will the money come from to pay for all of this? And what are the implications for the dollar, and for other spending, of a deficit of $1 trillion? That won't get sorted out next week in the rush to do a deal, but it will be a question on plenty of minds as negotiations over the package move ahead.