- The Washington Times - Monday, September 29, 2008

The $700 billion bailout package for the U.S. financial system represents a massive effort to thaw frozen credit markets and address a worsening solvency problem that already has claimed several major casualties on Wall Street.

Economists and banking analysts were unsure Sunday whether the biggest government intervention in the financial markets since the Great Depression will provide enough help to world credit markets or prevent the U.S. economy from falling into a deep, prolonged recession.

The rescue package “will provide a respite for a period of time, but it is no magic wand,” said Brian Bethune, chief U.S. financial economist for Global Insight, an economic consulting firm.

The rescue package that emerged from negotiations early Sunday morning differed significantly from the three-page proposal that Treasury Secretary Henry M. Paulson Jr. submitted to House and Senate leaders eight days earlier. Negotiators on all sides made major compromises on many issues.

“By far, taxpayers were better protected under the final plan than under Paulson’s original draft,” said Jared Bernstein, a senior economist at the liberal Economic Policy Institute.

What emerged from the negotiations represented an “improvement over Paulson’s draft,” Mr. Bethune said.

The additional provisions, including giving the Treasury the right to buy stock in companies it bails out, increased congressional oversight and restrictions on executive compensation, will give the program more flexibility and make it more palatable to taxpayers, he said.

The final plan authorizes the Treasury Department to begin purchasing troubled mortgages, mortgage-backed securities and other “toxic” assets from financial institutions whose balance sheets have been severely weakened by the housing bubble bursting, which was followed quickly by soaring foreclosures.

The housing crisis has already contributed to the loss of nearly 800,000 private-sector jobs since November. Senate Budget Committee Chairman Kent Conrad, North Dakota Democrat, said Federal Reserve Chairman Ben S. Bernanke told members of Congress that 3 million to 4 million Americans will lose their jobs in the next six months if the credit freeze continues.

The rescue package could reach $700 billion, but that sum will be available only in installments. Treasury will have immediate access to $250 billion and can obtain $100 billion more after the president makes a request. Congress could prevent the release of the final $350 billion by passing a joint resolution blocking the funds from being spent.

Financial firms participating in the program must provide the government with the right to buy nonvoting shares in the company, which will help limit the losses to taxpayers. At the end of five years, the plan requires the president to submit to Congress a proposal that recovers from the financial industry any projected losses to the taxpayer.

The Treasury secretary will be responsible for establishing the mechanisms for purchasing troubled assets and the methods for pricing and valuing those assets.

The package includes several provisions aimed at limiting executive compensation for firms participating in the program, including one that will assess a 20 percent excise tax on multimillion-dollar “golden parachutes” triggered by events other than retirement.

The package contains significant oversight mechanisms, including a board appointed by congressional leaders of both parties; an independent inspector general who would monitor the Treasury secretary’s decisions; the presence of the Government Accountability Office at Treasury to oversee the program and conduct audits; and a Financial Stability Oversight Board to review and make recommendations regarding the exercise of authority under the law.

A transparency provision requires all transactions to be posted on the Internet.

The Treasury secretary’s actions will be subject to judicial review, a marked departure from Mr. Paulson’ original proposal, which declared decisions by the Treasury secretary to be “non-reviewable” by any court or administrative agency.

Once the government obtains the mortgages and mortgage-backed securities, it can modify the loans, for example, by reducing the principal or the interest rate - an effort to reduce home foreclosures. Democrats had wanted to include a provision allowing bankruptcy judges to reduce the mortgage on a first residence, but it was not in the final draft. Democrats also agreed to drop a proposal to fund an affordable-housing program.

House Republicans were able to include in the plan their proposal to establish an insurance program whereby firms would pay risk-based premiums to the government to insure their troubled mortgage-backed securities.

Beyond slowing the economy, the crises in the financial, credit and housing markets have ravaged some of the biggest players on Wall Street and in the mortgage market.

But the rescue package is trying to revive an economy on the precipice, because of the profound weakness of its credit market.

“At this point, we are at the maximum point of stress,” Mr. Bethune of Global Insight said. “The economic patient is in critical condition, and there’s not enough oxygen to revive the patient.”

The economy desperately needs the Fed to lower interest rates by at least a half percentage point, he said. The Fed has already lowered its overnight target rate from 5.25 percent a year ago, when the financial crisis erupted amid soaring defaults on subprime mortgages, to 2 percent.

“Without the Fed lowering interest rates some more, the probability of the bailout plan’s success will be lower. The plan will succeed or fail depending on how soon the U.S. economy will turn around,” said Mr. Bethune, who projects that the economy will contract rather than grow during both the fourth quarter of 2008 and the first quarter of 2009.

“The financial markets are holding the greater economy hostage,” said Vincent Reinhart, a scholar on monetary policy and the global economy at the conservative American Enterprise Institute (AEI).

During the credit freeze that gripped the markets much of last week, both before and after bailout negotiations broke down Thursday afternoon at the White House, banks were afraid to lend to one another because they did not trust their competitors, Mr. Reinhart said.

“We have something worse than a liquidity problem. We have a solvency problem,” Mr. Reinhart said. “Helping the liquidity problem does not solve” the problem of bankrupt or insolvent businesses.

Unless the credit freeze is mitigated by the rescue plan, it has “the potential to be a serious drag on spending in an already-weakened economy,” said Mr. Reinhart, who completed a seven-year stint last year as the director of the division of monetary affairs for the Federal Reserve’s Board of Governors.

Mr. Bernstein of the Economic Policy Institute acknowledged in an interview that he was initially skeptical of Mr. Paulson’s extraordinary proposal, but he became “convinced of the urgency” by the end of the week.

As the financial system came close to a meltdown, it became clear that ad hoc interventions weren’t working and systemic action was necessary, he said. However, he lamented that there wasn’t enough in the final bailout plan that “gets to the cancer in the housing market,” which has become mired in soaring foreclosures and plunging home prices, which have left an estimated 10 million households owing more on their mortgages than their homes are worth.

“My hope is that there is enough in the plan to treat the symptoms in the credit markets,” Mr. Bernstein said. “It doesn’t treat the causes as much as the symptoms, but the symptoms became awfully scary last week.”

Mr. Reinhart of AEI acknowledged that the bailout plan was “not an efficient way of recapitalizing the financial system, but it may be a fairer way. If you wanted to inject capital into the system, you would have to do it firm by firm, and that is what the government does worst.”

Instead, the bailout plan will enable the government to raise the prices of the troubled assets for all firms in the market, eliminating the need for the government to provide capital to chosen firms. If the government enters the market in a substantial way, as the plan intends, it will have the power to raise the prices of the assets, Mr. Reinhart said.

“It’s hard to find better, workable alternatives. In this case, you can’t lift yourself up by your own bootstraps,” the former Fed economist said.

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