Financial Crisis 101: Inside Washington’s $700 billion plan to bail out Wall Street

UPDATE: Bailout bill fails; candidates play blame game

This article is the second in a two-part series on the ongoing Wall Street financial crisis. Friday’s piece focused on the underlying causes of the problem; today’s installment will examine the proposed government bailout plan and the implications of the current situation.

For the last week, America’s news cycle has been dominated by a single topic: the government proposal for a $700 billion “bailout plan” to rescue the nation’s embattled banks, lending companies, investment firms and other financial institutions.

Yesterday morning, congressional leaders on Capitol Hill announced a “tentative” agreement regarding the terms of the proposal after a tumultuous week that saw late-night legislative sessions and the suspension of Sen. John McCain’s (R-Ariz.) presidential campaign.

But what does the deal consist of? How will it work, and what are its implications?

The Daily sat down with some of Tufts’ economic experts to explore the proposal’s inner workings — and its potential flaws.

Buying bad debt

Since the financial crisis stems largely from risky loans that are unlikely to be repaid, politicians have been looking at ways for the government to alleviate the burden of those unpaid loans on the companies that lent them.

Enter the much-discussed $700 billion bailout package.

Though the term “bailout” connotes some form of a handout, the plan being considered does not involve the government simply giving money to troubled companies. Instead, it would authorize the U.S. Treasury to spend up to $700 billion to purchase assets — most likely the faulty loans and mortgages — from companies in trouble. The hope, according to Professor of Economics Enrico Spolaore, is that doing so would restore investors’ trust in these companies to prevent their complete implosion.

“The Secretary of the Treasury would be able to purchase assets, and he could purchase and sell whatever he wants as long as the balance of what he’s holding is $700 billion,” Spolaore said. “The idea is that by purchasing these assets, he would be able to inject enough liquidity and confidence so that the financial institutions that are holding these assets would not collapse.”

Economics Lecturer John Straub said the problem is largely one of liquidity — that is, the extent to which financial institutions have the ability to sell their investments, such as mortgages and real estate, and turn them into the cash they need to pay for their expenses.

“The short-term goal is to bail out the companies who currently hold the bad debt so they can get back to the business of financing our economy,” Straub said. “In the current situation, it is becoming almost impossible to borrow money — even for projects with excellent prospects of success. This is because the usual lenders are paralyzed by all the bad debts they currently hold.” A fragile compromise

That approach, while theoretically sound, presents a host of problems — many of which were hotly debated among political leaders over the weekend. Some Republicans have objected to the plan because it cedes too much power to the federal government; instead, they favor solutions that occur within the market, between private companies.

“Typically, when you have bad debt, a more typical way to approach it is not that the government buys the bad debt, but that you have a deal between the borrower and the lender so that the lender gets only a fraction of their debt back,” Spolaore said. “Another approach is an equity swap, were the lender becomes a stakeholder [in the property].”

According to Straub, another approach to preventing excessive government intervention would be inaction; the government could simply allow the markets to correct themselves.

“Once the market hits bottom, won’t the profit motive entice private investors like Warren Buffet to swoop in, buy when the market is at the bottom and sell later after the market improves?” he said. “This is logical, but two bad things would almost certainly happen before the market ‘hits bottom’ … the whole economy would probably go into a deep recession. Preventing such a recession is their justification for the [bailout] plan.

“The other bad thing is not used as a justification for their proposal: The companies and individuals who currently hold the bad debt would be wiped out,” he continued. “Warren Buffet’s gain would be their loss. Would that be fair? That’s a matter of opinion, but under the government’s plan, the current holders of the bad debt will be at least partially bailed out, depending on how much the government pays for the bad debt.”

Associate Professor of Economics Edward Kutsoati said that, were the government to back out of the bailout plan, the results could be disastrous.

“It would be huge … everything would freeze,” he said. “Certainly I would not be putting my money out there … I would put it in gold, maybe. I would keep it under my pillow.”

While the prospect of taking no action at all has hardly been discussed, members of both parties have criticized the current plan for potentially rewarding companies that made bad decisions in giving out risky loans.

“Something has to be done,” Kutsoati said. “The question is, how do you do it so that you help those who are in need but you don’t reward those who are responsible for this mess? That is a very, very difficult position. Some who are faulting through no fault of theirs would continue to hurt. Some who made money in such a way might be rescued in this case, and in between, you have other stories.”

Calculating the crisis

If the current proposal does go through, one of the major challenges will be deciding which faulty loans the government should purchase — and for how much.

“If the government buys all this debt, how much should it pay?”said Straub, giving the example of a hypothetical house that had been bought with a $100,000 mortgage, which would be worth much less today, as real estate prices have dropped over the past two years.

“It would seem crazy for the government to pay $100,000 for that mortgage,” Straub said. “But you can be sure that the current holder of the debt would want the government to pay for it. On the other hand, the house is almost certainly worth something. It would also be unreasonable to think that the government would end up losing 100 [percent] of its initial outlay.”

In other words, because the government is buying debt rather than simply giving out money, it will not necessarily lose the $700 billion it spends on the bailout. According to Spolaore, the net result could actually be an increase in the value of the loans the government buys.

“Some other economists think that maybe the government will not really have to subsidize this in terms of taxpayer money,” Spolaore said. “It all depends on your view. Are these assets now really underpriced?”

He said it is possible that many of loans and properties being purchased could increase in value.

“If the government buys this debt at the current market price or even a little bit above the market price, it might be a good deal down the road.”

But the government will have a difficult time figuring out how much to offer for the assets in question, according to Kutsoati.

“This whole bailout is going to try to put together all information,” he said. “So say we take a company, and we begin to assess their balance sheets — what kind of debt they have out there, what kind of collateral they have … and the question is, who really knows how to value these assets? Because you’d value a home at $600,000, and in the books it’s at $600,000, but [its actually price] has dropped to $400,000.”

Kutsoati said it’s hard to predict what effect the bailout plan, if implemented, will have. But either way, it will be a major change in America’s economy.

“One thing we know for certain,” he said. “The financial market as we know it today will no longer be the same after all of this.”