Will the $700 Billion Rescue Plan Work?

October 7, 2008 Updated: October 8, 2008

WASHINGTON—Economists and financial specialists can’t seem to agree on the viability of the $700 billion federal financial rescue plan, according to publications by Knowledge @ Wharton (KW), the publishing arm of the University of Pennsylvania.

Experts “don’t all agree that a taxpayer-funded purchase of troubled mortgage securities is the best way to attack the credit crunch,” according to a recent KW article titled “The $700 Billion Question: How Much is That Exotic Security?”

More questions then answers came out of the debates regarding the bailout. The key lies in how the government values “exotic securities” from distressed financial companies.

Here is the dilemma: if the government values the securities too high, hundreds of billions of dollars of taxpayer funds could go down the drain. On the other hand, if the securities are undervalued, the bailout may not succeed.

“The big question is, at what prices will the Treasury buy the debt?” said Richard Marston, finance professor at Wharton, the business school at the University of Pennsylvania.

Experts believe that the extras tagged onto the bailout package, such as raising the FDIC insurance cap for savings from $100,000 to $250,000, forming an oversight committee, curbing executive pay, requiring that the financial industry compensate taxpayers for any net losses after five years, will have little to no impact on the overall success of the asset-purchase plan.

Almost all economists and financial heavyweights “described the financial situation as perilous and said some sort of government response is needed,” according to the KW article.

Professors from Wharton are not sure if the plan will truly provide the banking industry with sufficient money to start lending again.

Mark Zandi, chief economist at Moody’s Economy.com, suggested that the bailout plan is the best that can happen—in such a short time period—to put the credit market back on track.

It is “a very elegant idea. The principal benefit is that it establishes a market price for these assets that have no price. This will allow banks to write down [losses] appropriately, which is absolutely necessary to get capital flowing back into the banking system,” said Zandi in a KW article.

Olivia S. Mitchell, insurance and risk management professor at Wharton, argues instead that the plan is a band-aid fix and does not address the fundamental problems of why the mortgage market went bust in the first place.

Mitchell is against the bailout plan because it leaves homeowners out of the equation. If the homeowners are left out in the cold, the bailout cannot succeed. Even with the bill, how will homeowners pay their monthly mortgages?

Others, such as finance professor Franklin Allen, worry that the government has not been transparent.

“One of the things that the government has not conveyed very effectively is the intellectual foundation of what they are doing,” suggested Allen.

Proponents Weigh In

Supporters of the plan suggest that distribution of the funds from the $700 billion bailout plan will bring lenders out of hibernation and inject the market with new vigor.

Federal Reserve Chairman Ben Bernanke warned of dire consequences and argued that without the $700 billion bailout, businesses will come to a standstill and ordinary Americans will suffer. Many would lose jobs and become unable to pay their bills or get loans.

According to the KW article, one proponent suggested that the government—and taxpayers—should come out on top, as it buys the distressed assets for less than a quarter of the original price. The U.S. government then could stimulate economic growth by pumping money into the credit market and sit on the assets until they reach acceptable price levels before disposing of them, something no investment firm or any other entity could do. 

Jeremy Siegel, finance professor at Wharton, agrees.

“Government purchases will help establish asset prices, encouraging other investors to look for bargains and possibly leaving the government spending far below the $700 billion called for in the plan,” Siegel said.

Allen argues that in the past, when an “asset bubble bursts,” the value of the asset will take a nosedive, and then slowly return to a more reasonable level and the intervener, the U.S. government, will get more than it initially pumped into the system.

Critics Sound Off

Many opponents of the bill are skeptical of the financial industry. First, it is very difficult to price the securities because of the way they are packaged. Secondly, the firms holding the securities will only sell the most toxic securities to the government and hold tight to ones they feel have potential. This could leave taxpayers with worthless securities.

To truly rate the toxic securities, one would have to “predict the rate of homeowner defaults and the timing of the default,” said the KW article.

There could be pitfalls in the loan packages, such as the location differential, which is often unknown in mortgage-backed securities. For example, a default may be more likely in New York or San Francisco than in Virginia or a somewhat stable region. But all of these loans may be in the same package.

“You have to get down to zip code-specific areas that are the collateral in the pool and project how severe the losses are. … You need someone who knows what they are doing, and there’s not too many of those around,” said William Frey, President of Greenwich Financial Services, in the KW article.

Some suggest that Treasury Secretary Hank Paulson’s plan is full of loopholes. There are so many security packages filled with both toxic and less toxic products—it may be impossible for the government to discern between the good, the bad, and the toxic assets.

Alternative Approaches

Some professors proposed alternative ways to alleviate credit market distress.

One proposal involves government loans to distressed financial institutions, where the lender takes mortgage securities as collateral.

Most approaches center on homeowners and mortgage borrowers. But supporters of such suggestions also envision complex problems and loopholes.

Such approaches would work if the mortgages were not packaged into securities and then sold to investors.

“The problem is that nobody in the chain of securitization has an incentive to renegotiate the initial price of the mortgage,” said Mitchell in the KW article.