As Congress and the Bush administration attempt to craft a $700 billion bipartisan plan to bail out the nation's financial industry, some taxpayers are understandably confused. To help readers better navigate this complicated process, the Observer posed some common questions to several of economic experts. Here are their edited responses.
Q: What exactly would the government buy from the banks?
The Treasury says it will purchase “residential and commercial mortgage-related assets,” which could include whole loans as well as mortgage-backed securities. But the Treasury's plan also gives broad discretion to the Treasury secretary and the Federal Reserve chairman to buy any other assets “as deemed necessary to effectively stabilize financial markets.”
“It could mean commercial loans, it could mean installment loans, we don't know anything,” said Ken Thomas, a Miami-based banking consultant. “We would hope it means well-collateralized loans that protect taxpayers.”
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Q: Where would the government get that $700 billion?
The U.S. Treasury would issue debt, which means the national deficit would increase and the government, in all likelihood, eventually would raise taxes to pay it off. Issuing debt also can drive up short-term interest rates, which makes it more expensive to borrow money.
Some supporters of the buyback plan, including Warren Buffett, predict that the government might actually make money through this plan, by reselling these assets at a higher price in the future. But even if the government did come out ahead, there's no guarantee it would return those profits to taxpayers by lowering taxes.
Q: How would the government value the troubled assets it's buying?
That's a big sticking point. Critics worry that the government might pay more for the assets than they'll ever be worth. No one has a surefire formula for valuing these bundles of securities. They're tied to thousands of individual mortgages, and assigning a price to them requires a lot of guesswork about how many of those mortgage holders will go into default and how much their homes would sell for in a foreclosure.
Some of these securities have plummeted from triple-A ratings to near junk status. In July, Merrill Lynch – which Charlotte-based Bank of America plans to buy – sold $31 billion of mortgage-related investments for 22 cents on the dollar.
Q: Why is it necessary for taxpayers to bail out these companies?
For one thing, the U.S. government is probably the only entity able to take on such a massive amount of bad assets, especially while other financial firms are trying to reduce the risk on their balance sheets.
Supporters say that without the bailout plan, the country's credit markets would freeze up and restrain lending and borrowing in the broader economy, and there's no telling how much that would cost the economy. “It's the principle of pay one dollar now or pay five later,” said Steven Mann, a professor of finance at the University of South Carolina.
Q: Why can't the markets work this out?
Government regulators say it's too risky to wait and see. Others disagree. Mike Munger, a professor of economics and political science at Duke University and the Libertarian candidate for N.C. governor, said there's no economic value in forcing taxpayers to bail out irresponsible bankers in “a temporary credit crunch” that “will sort itself out if we leave it alone.”
There's also no guarantee that pouring cash into the market will solve its fundamental problem – that it's based on unsound mortgages.
In a letter to Congress this week, BB&T Corp. CEO John Allison wrote that the markets should be allowed to work through their natural correction.
“Corrections are not all bad,” Allison wrote. “The market correction process eliminates irrational competitors. There were a number of poorly managed institutions and poorly made financial decisions during the real estate boom.”
He and others think that sound bites about a national financial panic are overblown. The panic, they say, is contained to high-risk institutions on Wall Street.
“I'm not worried that banks won't lend,” said Joe Gordon, of Gordon Asset Management in the Raleigh area. “The healthiest ones out there are lending right now. If you've got a good project, then BB&T and Wells Fargo are going to lend to you.”
Q: Didn't the investment banks know they were taking big risks when they bet on subprime loans?
Munger, the Duke professor and gubernatorial candidate, says that even if bankers realized that the swift rise in housing prices was a bubble, they couldn't necessarily pull out of those markets. “If they can keep making money on real estate, because other people keep buying real estate, then they're going to stay in even if they know it's a bubble,” he said. “Say they bail, and the market goes up 15 percent. If they don't beat the market they lose their jobs, even if the fundamentals are bad. It's a bad system, but it's not that they were stupid.”