After years of financial mismanagement, it took less than two weeks for the markets to come unglued. Now, Congress and the Bush Administration are trying to pass a fix within the week. But with the clock ticking and lobbyists circling, big questions remain.
A brief proposal sent to Congress by the Treasury Dept.—with a request for action before Congress adjourns on Sept. 26—would authorize the Treasury to buy up to $700 billion of toxic mortgage-related assets and gradually resell them, with few strings attached. That is roughly what the U.S. has spent to prosecute the war in Iraq to date, and nearly $2,300 for every man, woman, and child in the country. Added to the $200 billion that could go toward shoring up Fannie Mae (FNM) and Freddie Mac (FRE), and the $85 billion the government has pledged to acquire most of insurance giant American International Group (AIG), the potential price tag for taxpayers soars to near $1 trillion. That's just under half what the country spends annually on health care.
Already, some in Washington are seeking to downplay the numbers. Treasury Secretary Henry Paulson and Representative Barney Frank (D-Mass.) have both stressed that while the Treasury has asked for $700 billion to spend up front, the government ultimately will recoup some of its costs over time by selling the assets it acquires. But it's impossible to say just how much the government will be able to recover or how much in the way of impaired assets it will need to buy before the financial system stabilizes. "We can't determine the costs today," Paulson said on Sept. 21 on NBC's Meet the Press.
Tax Hikes Necessary?
Whatever the eventual price tag, there's little doubt that the rescue will swell an already ballooning budget deficit, which some predict could top $1 trillion next year. Even before any of the spending to stabilize the financial sector, the deficit was projected to reach around $500 billion. Paulson has proposed raising the ceiling on the federal government's accumulated debt to $11.3 trillion from $10.6 trillion, and while some congressional Democrats are considering demands that any increase be limited to the bailout, there is little doubt that the next President will inherit a bigger financial challenge than expected. That would mean even greater constraints on plans for spending and tax cuts, proposals already straining the bounds of the possible. The more funding the financial bailout demands, the tougher the trade-offs the winner will have to consider when it comes to his priorities. Spending on health-care reform or tax cut packages will likely take the first hit. "You are about to put a giant hole through the budget," says Daniel Clifton, policy analyst for Strategas Research Partners, who predicts tax hikes no matter who wins in November. "You just can't raise the deficit to $1 trillion."
Moreover, it's far from clear that the final plan will retain the stripped-down structure of the original. Despite promises by lawmakers not to turn the legislation into a virtual "Christmas tree," with everyone adding their own favorite goodies to the bill, pressure is already growing to add to it, whether as part of the same bill or in parallel. One likely addition: relief for homeowners struggling to pay their mortgages— arguably the heart of the crisis, since those mortgages underlie the securities weighing down financial companies' balance sheets. Prominent Democrats, including Presidential candidate Barack Obama, argue that the government's bailout shouldn't aid only big corporations and their investors.
Frank, speaking Sunday on CBS News' Face the Nation, suggested help for homeowners could be funded in part by "a surtax on the wealthiest people in the country, who are among those who made these mistakes. It's almost as if we let them take the economy hostage by not having the appropriate financial regulation."
Already a few, including Senator Bernie Sanders (I-Vt.), have threatened to vote against a bill that lacks aid for homeowners. "If the economy is on the edge of collapse, we need to act," Sanders said in a Sept. 21 statement. "But rescuing the economy does not mean we have to just give away $700 billion of taxpayer money to the banks."
A Lobbying Extravaganza
Industry and the GOP have called for a "clean bill," setting the stage for a fight. "In adding extraneous provisions, you risk killing the whole thing," warns Scott Talbott, senior vice-president for government affairs at the Financial Services Roundtable. "No one wants to do that." On the talk show circuit on Sept. 21, Paulson tried to frame the package as one that helps both Wall Street and Main Street: "When companies can't borrow money…it's difficult to get jobs, it hurts people's budgets, it hurts people's retirement savings," he said. "It pains me to have the American taxpayer put in this situation, but it's better than the alternative."
At the same time every wing of the financial sector, among others, has turned its sights on Capitol Hill, anxious to protect their interests in the final measure. Talbott called the scrum shaping up inside the Beltway the "Super Bowl and New Year's Eve of lobbying," with the main event likely to start on Sept. 22. Among the measures likely to surface: calls to loosen requirements that companies report the "fair value"—typically the market value—of mortgage-related securities on their books. Advocates say such a move would make it less likely that companies spiral toward bankruptcy as they repeatedly mark down such assets. Critics say the move would merely obscure the true financial risks posed by the securities to both the companies and the economy.
The rescue plan is also brushing against other long-simmering legislative debates, including Beltway bickering over the need for a second economic stimulus package before November's election, which could include enhanced unemployment benefits and infrastructure spending to create jobs: Democrats are for it, many Republicans skeptical. Democrats backing a bill to let bankruptcy court judges modify mortgage terms, including how much is owed—much as other debts can be modified in bankruptcy—say the measure is a natural fit in any housing relief bill. The financial-services industry disagrees strenuously.
Few Checks on Treasury
There is little question that the rescue proposal is fluid. The Administration has indicated it is willing to accept at least some measure of relief for homeowners. And, while the Treasury's original proposal let the government buy assets only from U.S. financial institutions, Paulson indicated on Sunday that foreign institutions with U.S. operations could also benefit.
The mechanics of the final plan could also bear heavily on its success—and its ultimate acceptance by taxpayers and voters. As it stands, the Treasury's proposal lets that agency make all the decisions, with periodic reports to Congress but few checks otherwise. The agency would hire managers to handle its purchases and sales and potentially repackage securities in between. What guidance they would receive from the Treasury, and what compensation, remains an open question.
And with the Treasury potentially committing hundreds of billions of dollars to buy dubious financial assets from shaky financial institutions over the course of two years, another critical question remains unresolved: at what price? The Treasury has said it would try to pay "market prices," perhaps using reverse auctions, but the market for the securities has all but seized up in recent weeks. Merrill Lynch (MER) sold a chunk of mortgage-backed securities for about 22¢ on the dollar earlier this summer. Other firms value their securities much higher than that, leaving a central question: What is a good guideline for Treasury acquisitions?
Pay too much, and the rescue plan begins to smack of a bailout—or even a windfall for what remains of Wall Street. Indeed, the less the government pays, the better its odds of breaking even on the bailout or even turning a profit when it is eventually able to sell off the assets. But pay too little, and the fix could prove not much better than the crisis—which, after all, stems in large part from writedowns of these very assets —minimizing any benefit from the government stepping in at all. The risk is that the government becomes a "dumping ground," says Lawrence White, a New York University economist. "Do we want to have a government entity buying difficult-to-value assets at God knows what price?"
No Relief for Hedge Funds
Then come the related questions: What will the government actually buy, and from whom? The proposal's vague language gives Treasury broad leeway to buy up "mortgage-related assets"—but the Treasury made clear that, after consulting with the Federal Reserve, it could buy assets beyond whole and securitized loans, potentially including derivatives based on the value of those mortgages. Some observers speculate it could even mean wading into the enormous market for credit default swaps, those contracts that rise and fall on the creditworthiness of a range of financial and nonfinancial companies.
As for where the government makes its purchases, the Treasury's proposal initially seemed to limit the relief to commercial and investment banks. It's less clear whether insurers would qualify. Hedge funds need not apply. Yet, as AIG's collapse and bailout show, large insurers have become inextricably entwined in many aspects of the U.S. financial system. And investment banks' proprietary trading desks have swollen in recent years, allowing them to make sometimes giant bets in the market using the firms' own money, much as an in-house hedge fund would. As the weekend closed, financial-services lobbyists were poised to make the case that the final measure should cover not just banks and insurers, but mortgage originators and bank affiliates as well, and allow the Treasury to buy commercial loans tied to housing and real-estate construction in addition to residential and commercial mortgages.
Then there's the question of accountability: What should the government demand in return from the companies it bails out? As the Treasury's proposal stands now, financial firms are spared sacrifices. The plan proposed no tighter limits on the leverage they can carry, no changes to corporate governance, no requirement that they better disclose the risks they face or the assets underpinning their balance sheets. Also unresolved: whether the executives who piled on the debt and raked in the shaky securities should have to return any of what they made along the way. Frank, the Massachusetts Democrat, is leading the charge in Congress to add compensation limits to rein in the pay of executives whose companies benefit from the bailout. Although the Presidential candidates have both lambasted executive greed with increasing vigor in recent days, banking lobbyists are sure to oppose any such move. And Paulson warned that such reforms should come after the markets have stabilized.
Candidates Demand Accountability
On the campaign trail, the candidates hewed closely to their earlier positions: measured support for the Treasury's proposal, demands for accountability, and reassurances that they were looking out for average Americans.
At an appearance in Charlotte, N.C., on Sunday, Obama criticized the Administration for offering only "a concept with a staggering price tag, not a plan." He said the final proposal should include provisions ensuring that companies aided by it also share in its cost, help struggling homeowners remain in their homes, and coordinate with other countries. He also called for an economic stimulus package. "We must work quickly in a bipartisan fashion to resolve this crisis to avert an even broader economic catastrophe," he said in remarks prepared for the appearance. "But Washington also has to recognize that economic recovery requires that we act not just to address the crisis on Wall Street, but also the crisis on Main Street and around kitchen tables across America."
Republican Presidential candidate John McCain, too, has called for an end to corporate bailouts. On Sept. 19, he said he would reserve judgment of the Treasury's plan until its details became known, but reiterated his own proposal for a new division of the Treasury to buy up questionable mortgage-related assets. His proposed "Mortgage & Financial Institutions Trust," would help companies identify bad loans, lend money at reasonable rates, "provide funding and eventually sell them at a profit." In return, the agency would receive warrants for "controlling interest in troubled institutions." Financial companies under the proposal would "keep operating as private companies" with the new agency's help.
Francis is a correspondent in BusinessWeek's Washington bureau
Sasseen is BusinessWeek's Washington bureau chief