Reviewing The Current Bailout Proposal

Let’s take a look at the summary of the current proposal before Congress, as well as taking a look at how the bailout will actually function.

First here is the summary of the draft proposal currently sitting before Congress:

(From the WSJ):

I. Stabilizing the Economy

The Emergency Economic Stabilization Act of 2008 (EESA) provides up to $700 billion to the Secretary of the Treasury to buy mortgages and other assets that are clogging the balance sheets of financial institutions and making it difficult for working families, small businesses, and other companies to access credit, which is vital to a strong and stable economy. EESA also establishes a program that would allow companies to insure their troubled assets.

II. Homeownership Preservation

EESA requires the Treasury to modify troubled loans – many the result of predatory lending practices – wherever possible to help American families keep their homes. It also directs other federal agencies to modify loans that they own or control. Finally, it improves the HOPE for Homeowners program by expanding eligibility and increasing the tools available to the Department of Housing and Urban Development to help more families keep their homes.

III. Taxpayer Protection

Taxpayers should not be expected to pay for Wall Street’s mistakes. The legislation requires companies that sell some of their bad assets to the government to provide warrants so that taxpayers will benefit from any future growth these companies may experience as a result of participation in this program. The legislation also requires the President to submit legislation that would cover any losses to taxpayers resulting from this program by charging a small, broad-based fee on all financial institutions.

IV. No Windfalls for Executives

Executives who made bad decisions should not be allowed to dump their bad assets on the government, and then walk away with millions of dollars in bonuses. In order to participate in this program, companies will lose certain tax benefits and, in some cases, must limit executive pay. In addition, the bill limits “golden parachutes” and requires that unearned bonuses be returned.

V. Strong Oversight

Rather than giving the Treasury all the funds at once, the legislation gives the Treasury $250 billion immediately, then requires the President to certify that additional funds are needed ($100 billion, then $350 billion subject to Congressional disapproval). The Treasury must report on the use of the funds and the progress in addressing the crisis. EESA also establishes an Oversight Board so that the Treasury cannot act in an arbitrary manner. It also establishes a special inspector general to protect against waste, fraud and abuse.”

Here are some additional clarifications on key aspects of the bill:

(From Forbes): “Under the legislation Treasury will be granted $700 billion in phases to acquire bad mortgage assets from financial institutions at a price it determines or through auction with a market price. If the Treasury decides to take the first option it will have some authority to determine the executive compensation structure of the firm.

If firms sell more than $300 million in assets in the auction, they will lose the ability to deduct the salaries of their top five individuals that have exceeded $500,000. For participating firms there will also be a surtax of 20% on retirement packages of top executives who are involuntarily terminated from their firms, or lose their jobs as a result of the firm’s failure.

According to the terms of the bailout agreement, the Treasury would be allowed to buy $250 billion in troubled assets immediately. The president could request an additional $100 billion at any time. Congress has the right to not approve the remaining $350 billion; however, that action is subject to the president’s veto. Since there is no date associated with this final amount, all of the money could be spent by the Treasury relatively quickly. Paulson has indicated that Treasury may be prepared to start purchasing assets within weeks.”

Finally here is a graphic depicting how the bailout plan might workout in practice:

Graphic courtesy of the WSJ

While I’m much happier with current proposal than I was with what the Treasury proposed last week, let’s be clear that my “happiness” is in terms of the current proposal being a lesser bad idea than the original.

Let’s look at some of the specifics:

Executive Compensation: I wonder if the limits on compensation will have much teeth, because I could see a company saying: “okay we were going to give you $15 million, but due to taxes imposed under EESA we’ll just have to give you $11″. Whether it’s $15 million or $11 million the fact that the executive received anything is theft pure and simple, and when you consider that who is making decisions on compensation, the amount of securities to sell, etc, it’s hard to believe that executives are truly going to suffer.

Protecting the Taxpayer: while I like the idea of a fee imposed on all institutions in order to recoup the taxpayer’s losses under the program, I’ll reserve judgment (positive or negative) until I see how much the fee is and what the overall program looks like. At this juncture there is little point in saying much about something that is completely hypothetical.

Mortgage Modification : the inherent problem with mortgage modification is that you can’t “modify” your way out of a situation where the homeowner simply spent above their means, without reducing principle, handing them cash, supplementing their income, etc. It’s great to say that you’ll “encourage” servicers to modify loans, or modify the ones you currently own, but affordability is the true root cause here. In my opinion while these provisions may help “some” homeowners, it will have a rather limited effect on declining housing values, foreclosures, etc.

Funds Allocation : the thing I like the most about the plan is that it’s only releasing $250 billion up front, with another $100 billion via Presidential approval and the final $350 billion being released only via Congressional approval. For me this isn’t just about limiting taxpayer liability in case the first “dose” of cash unclogs things, it presents the opportunity to shift course if/when the plan proves to be ineffective and/or to refocus on root causes as opposed to symptoms.

At the end of the day I think the current plan is just a moderately improved version of something that was a bad idea in the first place, if you want to fix the financial system address the issue of derivatives, regulatory arbitrage, undercapitalization, over leverage, etc, not just one of the symptoms. I suspect that I’m not the only one who is of this opinion, because if the recent performance of the credit markets, capital markets, et al, are of any indication the market is none too impressed by the bailout plan either.

If the bill is passed by Congress and signed into law by the President the question we should all begin asking ourselves is: “what happens 2-3 months from now when it becomes readily apparent that we created the wrong plan for the wrong problem?”

You can read more here(the WSJ), here(Forbes) and here(full text of the bill).

Sources:

The WSJ: “Summary of Draft Proposal to Rescue U.S. Financial Markets” — September 28, 2008.

Forbes: “What’s in the Bailout Deal” — Brian Wingfield and Joshua Sambrun, September 28, 2008.

Subscribe by RSS Subscribe by Email