After a tense week of negotiations, the House of Representatives has put out a 110 page draft of the bailout bill, called the Emergency Economic Stabilization Act of 2008. Events leading up to the bill included late night calls to Warren Buffett to get his take on the crisis and the consequences if the Bush bailout bill was not passed. “We are looking over a precipice in terms of the economic condition of the country for the next few years,” Buffett said during an interview on the Fox Business Channel. “If Congress doesn’t help us on this, heaven help us.” So let’s dive into the bailout plan and see exactly what it does, what it will cost, and whether it will work.
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Bailout Plan’s Key Provisions
The purpose of the Emergency Economic Stabilization Act is to “to immediately provide authority and facilities that the Secretary of the Treasury can use to restore liquidity and stability to the financial system of the United States.” Specifically, the bailout authorizes the Secretary of the Treasury, through a newly created Office of Financial Stability, to purchase commercial and residential mortgages and any securities related to such mortgages.
In addition, the Act permits the Secretary to buy, subject to certain notice provisions, any other financial instrument if the Secretary determines it is necessary to promote financial market stability. This authority that extends beyond mortgages is important, and likely means that the Secretary will purchase some level of credit card and education loan related financial instruments, among others.
The Bailout plan also would establish the Financial Stability Oversight Board (Sec. 104). The FSOB would be tasked with reviewing the exercise of authority under the Act, that is, keeping an eye on how the Secretary of the Treasury spends the taxpayers’ money. The FSOB will be comprised of the Chairman of the Federal Reserve, the Secretary of the Treasury, the Director of the Federal Home Finance Agency, the Chairman of the Securities and Exchange Committee, and the Secretary of Housing and Urban Development.
How much will the Bailout cost?
Much has been said about the $700 billion price tag of the bailout. While it is difficult to predict the ultimate cost to the taxpayers, one thing is clear, it will cost a lot LESS than $700 billion. Here’s why.
The Bailout plan does provide that the Secretary, subject to certain approvals, can have access to up to $700 billion to purchase troubled assets. According to current Section 115, the Secretary would be given immediate access to $250 billion, have easy access to another $100 billion, and have access to another $350 billion subject to Congressional denial.
It is important to understand that the Secretary is authorized not just to buy troubled assets, but also to sell the assets that are bought. That means, among other things, that the Secretary cannot hold more than $700 billion in purchased assets. If he buys and then sells certain assets, however, he can use the proceeds of the sale to purchase additional assets, subject always to the $700 billion limit.
Ultimately, how much the taxpayers pay for the bailout depends on how much the Secretary pays for the troubled assets and what his successor eventually sells them for. It is likely, in my opinion, that the Secretary will overpay (or pay at the high end of a reasonable pricing range) for the troubled assets. Why? To inject liquidity into the market. Here’s how Warren Buffett suggests the Secretary goes about determining the value of these assets:
[If] they do [the bailout] right, I think they’ll make a lot of money…. They shouldn’t buy these debt instruments at what the institutions paid. They shouldn’t buy them at what they’re carrying, what the carrying value is, necessarily. They should buy them at the kind of prices that are available in the market. People who are buying these instruments in the market are expecting to make 15 to 20 percent on those instruments. If the government makes anything over its cost of borrowing, this deal will come out with a profit. And I would bet it will come out with a profit, actually…
You can be pretty fanciful in marking positions in Wall Street, particularly when things aren’t trading. The one thing you want to make sure, when the Treasury is buying things, is the marks they have don’t make any difference. Like I said, it wouldn’t be a bad idea, if you’re buying ten billion of a security and you’re the Treasury, to have them sell five-hundred million, or something like that into the market, so you find out what the real market price is and then buy the other 9-1/2 billion at that price. I really think, I really think the Treasury will make — I think they’ll pay back the 700 billion and make a considerable amount of money, if they approach it in that manner.
In the final analysis, only time will tell just how much this bailout will cost. In an interview today, Representative Barney Frank pegged the cost at around $100 billion. A lot of money, to be sure, but not $700 billion.
Will the bailout work?
That’s the $700 billion question. Part of the difficulty in answering it is defining exactly what the bailout is intended to fix. It will bring some level of certainty, stability and liquidity to the financial markets, which they desperately need. Hopefully, the bailout will help to stabilize real estate prices. But the bailout will not fix what really threatens the economic future of our country.
From consumers to government, we have become a society of over-consumption. The federal government over-consumes and will continue to do so under either an Obama or McCain administration. State and local governments over-consume, many running substantial deficits. And individuals over-consume. We have gotten away with this insatiable consumption due to the massive wealth of our country, built up over decades of American ingenuity and hard work. But the party can only last so long.
Now we face mounting competition from countries like China and India. While we are busy consuming, they are busy investing and developing. So will the bailout work? It will be a very expensive and embarrassing band aid on a financial wound that could have caused massive disruption in our economy. To that end, I believe it will work. But what it does not address is the financial cancer that has been growing in our country since the 1980s. And with the political pandering to the middle class that we call presidential politics, I expect the financial cancer to metastasize, if it hasn’t already.
In addition to the core aspects of the bill, the emergency legislation has some other interesting provisions. For example, section 110 provides for certain modifications to some residential mortgages, including lowering interest rates and reduction of loan principal. Mortgages that would be eligible for such assistance include those held by HFA, which now controls Freddie Mac and Fannie Mae.
You can read the full text of the proposed bailout plan here: Emergency Economic Stabilization Act of 2008.