Experts and The Alternatives to $700 Billion Bailout

Gary has prompted me to make this post. I read this article by Anthony Faiola and David Cho of The Washington Post and it feeds into exactly what we both were saying. Since I couldn't say it any better, I'm attaching this article to my blog:

From MSNBC.com
Experts offer alternatives to bailout
Leading economists argue that other solutions could address financial crisis
By Anthony Faiola and David Cho
The Washington Post
updated 10:38 p.m. CT, Tues., Sept. 23, 2008

To hear Henry M. Paulson Jr. and Ben S. Bernanke tell it, there is only one plan to save the economy -- use $700 billion in taxpayer money to take the worst of Wall Street's assets off its books.
But leading economists and financial thinkers argue that there are a host of alternatives that would reduce taxpayers' liabilities and perhaps more effectively address the urgent crisis in financial markets. Although these experts concede that the clock is ticking, they say different approaches have been dismissed too quickly.
While the government's plan is built around buying troubled assets, other options offer sharply different visions.
One approach seeks to reduce taxpayers' liability by offering collateral-backed loans to troubled banks, leaving them to work out their own solutions. Another idea is to have the government set up a profit-driven investment fund with the aim of infusing the financial system with cash without taking on bad debt. Still others suggest radically different tactics of directly helping homeowners by reducing mortgage principal or bolstering banks by suspending capital gains taxes.
The administration has said it is willing to negotiate key parts of its plan -- including a possible concession allowing the government to take equity stakes in financial firms in exchange for bailing them out -- but senior officials stand by the fundamental approach they have adopted to solve the crisis.
"They presented this as a comprehensive, decisive solution, but it's clearly not comprehensive and probably not decisive," said Simon Johnson, a former chief economist at the International Monetary Fund and a professor at Massachusetts Institute of Technology.
The cost of a mistake could be huge. It could result in a catastrophic collapse of the U.S. financial system that could ripple across the world or in a staggering clean-up bill for taxpayers. At the core of the debate is whether Paulson, the former chief executive of Goldman Sachs now charged with rescuing Wall Street as Treasury secretary, and Bernanke, the Federal Reserve chairman and one of the leading academics on financial crises, are serving up the best possible recipe for purging the U.S. financial system of billions of dollars worth of distressed mortgage-related debt.
Under the administration's rescue plan, the Treasury secretary would have broad discretion to buy up to $700 billion worth of troubled mortgage-backed assets and other securities that Wall Street firms have been struggling to sell. Administration officials hope that once those assets are cleansed, money will flow freely through the financial system once again and that the government can hold onto the securities until they recover some of their value.
In testimony on Capitol Hill yesterday, Bernanke and Paulson explained that they formulated their plan after considering past crises, from the U.S. savings-and-loan bailouts of the 1980s to the bursting of Japan's economic bubble a few years later. But they ultimately decided that the response to the current crisis needed to be a fast and massive fix.
"The situation we have now is unique and new," Bernanke said. He later continued, "The firms we're dealing with now are not necessarily failing, but they are contracting. They are de-leveraging. They're pulling back. And they will be unwilling to make credit available as long as these market conditions are in the condition they are."
Many of the alternatives fall under four basic approaches:
Government as lenderCritics of the administration's plan argue that an alternative could be crafted to minimize the exposure of the government -- and taxpayers -- to risk. Johnson, the MIT professor, suggested that the government, instead of taking on the bad debt, could offer loans to troubled banks, allowing them to put up their sickened portfolios of mortgage-backed debt as collateral.
This would give the banks access to badly needed cash at attractive interest rates set by the government. But it would not completely let them off the hook for making those bad investments in the first place. Because government money would come in the form of loans, rather an outright purchase of the risky investments, taxpayers would be offered greater protection. Ultimately, the banks would have to pay off the loans and take back the securities, though at a time when the market for them may have improved. If the value of the securities is still depressed, that would be the banks' problem, not the taxpayers'.
"The risk to the government/taxpayer is that the bank goes out of business and so isn't around to settle up," Johnson said. "But the government is also the regulator, and they can do a more forceful job of making sure the banks have enough capital, so the incentives are pretty well aligned."
Interest rates would be set at a level attractive to banks, the relatively low rate at which the Treasury borrows plus a small premium. Only if the banks were nearing default would the government take a more active role in propping them up, perhaps even taking them over outright.
Government as hedge fundSome market analysts and fund managers worry that the Paulson plan would allow Wall Street to dump the worst kind of mortgage securities on the federal government. One solution could be the establishment of a fund that limits its purchases to profitable mortgage securities and other assets.
The creation of a $700 billion investment fund could help reinvigorate the business of trading mortgage securities, greasing the wheels of the credit markets by bringing in a new, cash-rich investor: the federal government. While this solution runs the risk of not cleaning up enough of the bad debt on firms' books, taxpayers could be more confident of getting their money back because the government would be selective about which securities it bought.
Mortgage breaksLiberal thinkers say the government could intervene in the financial system by addressing the ailing mortgages at the heart of the crisis. Under this approach, the government could reduce the amount of principal that struggling homeowners owe.
"It's about foreclosures, stupid," said John Taylor, chief executive of the liberal National Community Reinvestment Coalition.
One idea is for the government to take control of some mortgage-backed securities -- most likely by buying them from financial firms -- and then work to restructure the underlying loans into something homeowners could afford. The value of the securities, both those bought by the government and those in private hands, could improve as foreclosures and late payments drop. If so, financial firms holding mortgage-backed securities could see a recovery in their balance sheets.
To make it fair for homeowners who keep up with their payments, borrowers who receive federal help would be required to give the government some of their gains if they eventually sell their homes for a profit.
But advocates of the idea acknowledge that it may take time to address the problems of millions of struggling homeowners. In the meantime, critics of this approach say the financial system could fall into chaos.
Tax breaks for Wall StreetConservative analysts take a different tack, though their criticism of the Paulson plan has been no less sharp. They say that because the proposal forgives Wall Street for its past sins, it creates an incentive for investors to behave irresponsibly in the future.
Some of these thinkers complain that the government's rescue punishes taxpayers too severely for Wall Street's mistakes. They propose a cheaper alternative that calls for the repeal of the capital gains tax for two years, which would provide Wall Street a stimulus to reinvigorate the financial system.
Accounting rules that require banks to estimate the market value of their troubled mortgage securities would also be suspended for five years, giving financial firms the ability to value these assets at prices more reflective of the market before the panic gripped Wall Street.
Rep. Jeb Hensarling (R-Tex.) said this plan, which he announced on Capitol Hill yesterday, was still being finalized. Hensarling said the precise cost of the capital gains tax repeal, for instance, was still being determined.
"We agreed that inaction is not an option, but that doesn't mean that we've concluded that the Paulson plan is the only option," said Hensarling. "There are alternatives to consider, and we think we have a worthy one."
All of these alternatives try to get at the root of the turmoil facing the financial markets and the economy but in different ways. According to Lawrence Summers, former Treasury secretary, the government might have to try multiple approaches.
"If you have hypertension, you're way overweight and you're in the process of having a heart attack, what's your most fundamental problem? It's really not that useful to distinguish between them," Summers said at a Brookings Institute forum. "They're all components of the situation, and you're not going to get to a very satisfactory place unless you address all of them. That's how I think of our financial reality right now."
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