Paulson and Bernanke's banking bailout: The devil's in the details

Within the span of a week, Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke have gone from saviors to Satans. First, their plan for bailing out failing financial companies and thus shoring up a shaky economy was heralded as overdue medicine for a fast-spreading and perilous financial flu. Then, within days, it came to be lambasted as a gift to their friends on Wall Street and a power grab by the Bush administration. Financial experts at the W. P. Carey School of Business say Paulson and Bernanke's plan is neither as divine as its early proponents claimed nor as dastardly as its detractors now allege. It is, they say, necessary to reassure skittish investors and bankers around the world. But as is so often the case when Washington meddles in markets, its ultimate success will depend on critical details that are still being hammered out.

Within the span of a week, Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke have gone from saviors to Satans. First, their plan for bailing out failing financial companies and thus shoring up a shaky economy was heralded as overdue medicine for a fast-spreading and perilous financial flu. Then, within days, it came to be lambasted as a gift to their friends on Wall Street and a power grab by the Bush administration.

On Capitol Hill on Tuesday, Sen. Chris Dodd, a Connecticut Democrat, quipped, "After reading this proposal, I can only conclude that it is not only our economy that is at risk, Mr. Secretary, but our Constitution, as well." Financial experts at the W. P. Carey School of Business say Paulson and Bernanke's plan is neither as divine as its early proponents claimed nor as dastardly as its detractors now allege. It is, they say, necessary to reassure skittish investors and bankers around the world.

But as is so often the case when Washington meddles in markets, its ultimate success will depend on critical details that are still being hammered out. "Speed is of the essence," says Herbert Kaufman, vice chair of the finance department. "What's critical is taking illiquid assets off the books of financial institutions, so lending in a normal fashion can start again."

Financial freeze

Last week, lending, on which any healthy economy depends, effectively froze, as banks lost faith in each other's financial health and tried to unload securities, especially bonds backed by mortgages. That process created a downward spiral. As firms tried to sell, that pushed down the price of the securities. As prices fell, more people panicked and tried to liquidate, further depressing values. At the same time, with fear gripping the market, banks held tight to their cash, rather than lending it out.

"The basic problem that has dogged us since Bear Sterns is counterparty mistrust," Kaufman explains. Bear Stearns, a New York investment bank, appeared headed toward bankruptcy back in March, when the Treasury and the Fed forced its sale to J.P. Morgan Chase, a New York commercial bank. Since then, the Treasury and the Fed have teamed up to take control of Fannie Mae and Freddie Mac, the giant mortgage lenders, as well as insurer AIG.

At the same time, the Fed, the nation's central bank, has pumped money into the economy in an effort to encourage lending. But so far, none of those steps has stemmed the fears. "People think the guy across the table may not be there tomorrow, so there's a lot of reluctance to trade with or loan money to them," Kaufman says. "You're seeing it extend now to consumer loans, too — if you want to borrow money right now, you'd better have a stellar credit rating."

f the credit freeze continues, it could soon imperil the rest of the economy, which so far has chugged along in spite of the stresses in the financial markets, says Werner Bonadurer, a clinical professor of finance and former executive for UBS, a Swiss bank.

"Businesses are going to starve if they can't borrow," he explains. "They need access to working-capital loans. Even good businesses will go under because they run out of liquidity." Big manufacturers like General Motors and General Electric routinely extend credit to their customers. But they can only do that because they can turn around and borrow short-term money elsewhere. If they can't borrow, the economy's gears jam, and growth slows.

"That's the biggest risk to the economy," Bonadurer says. Similarly, the real estate market won't recover unless the mortgage market returns to normal. "If you don't give people mortgages, how will you ever see a stabilization of house prices?" Bonadurer asks. Without mortgages, most people can't buy. And without buyers, prices will continue to fall.

The Paulson/Bernanke bailout plan

Faced with the financial crisis, Paulson and Bernanke last week proposed a bailout that would be unprecedented in its scope. They've asked Congress for $700 billion, which would be used to buy up bad mortgages and derivative securities created from those mortgages. They are, in essence, making a twofold wager. First, they're hoping that the panic will abate and normal lending will resume once people realize that banks can unload their bad investments and thus avoid insolvency.

Second, they're betting that, after the market calms, those mortgages and mortgage-backed securities will increase in value, and the government will be able to sell them at a profit. "If this stuff is held at 50 cents on the dollar on people's books, the Treasury buys it at 35 cents on the dollar and the market says it's worth 30 cents on the dollar today, then the government is giving a 5-cent subsidy" to the financial sector, Kaufman explains. "But maybe the government holds the security for two years, and maybe it returns 40 cents on the dollar."

Sound financial logic seems to underpin Paulson and Bernanke's plan, but its staggering amount plus a lack of details and no provision for oversight of the Treasury's actions stirred an outcry when the two men presented it to Congress on Tuesday. Some lawmakers called too costly. Others, too vague. And some accused Paulson and Bernanke of trying, in effect, to appoint themselves czars of the financial world.

On top of that, several lawmakers, including Sen. Dodd, who chairs the Senate Banking Committee, argued that, if the government is going to hand out so much cash, it should get stock in the companies that receive the money. If taxpayers bear the risk, this line of thinking goes, they should also receive the reward.

The current climate of tumult and uncertainty is thwarting efforts at making a reasoned assessment of the Paulson-Bernanke plan. And much about the plan is a leap into the unknown, says Robert Marquez, a finance professor. "Something you have to consider — and we may never know this — is what would happen if there wasn't a bailout," he points out. "We'll never know what the counterfactual is.

Suppose you'd let [insurer] AIG go under. Paulson and Bernanke's argument is that you could have [ended] up with a global meltdown. Maybe that's true. Maybe it isn't. We'll never know." Marquez sees an analogy with concerns about Y2K and the possibility that it could have crashed computers worldwide. After the date passed without incident, many folks dismissed the earlier warnings as bogus.

"So many people were saying that it was scare tactics by the software companies to get people to upgrade their systems," he says. "The missing part is that nothing probably happened because we spent the money." Likewise, after the current crisis passes, if the Federal Reserve and Treasury's massive intervention in the market works as intended it may seem like overkill. Everything will return to normal, and Paulson and Bernanke could look like Chicken Littles. In other words, they could be heroes if they end up looking like fools.

How bad is it?

Marquez believes that the skepticism that they've confronted stems partly from a sense that, at this point, no one really knows the extent of the problem. "I read an article asking where the $700 billion figure came from," he says. "Some government report had said the liability was something like $500 billion. But some other report said $1.1 trillion. It looks like they just chose a number in the middle."

The fact that no one really knows which figure is right raises another question: How did Wall Street, with its legions of richly compensated bankers, traders and analysts and its farms of cutting-edge computers, overlook the risks of subprime mortgages and mortgage-backed securities?

"Part of the problem was that people didn't correctly take into account the correlation in the risk of these assets," Marquez says. "You might have called something triple A because it had a low default probability, and that rating may have been good. But people didn't realize that all of these securities were tied to the same thing — the boom in the real estate sector. When that turned, they all tanked at once.

"If you look at models of credit risk, one of their weakest points is how they measure the overall risk of the portfolio. They seem to do a good job on individual credit risk. But they're haphazard on the overall portfolio risk." Regulators, too, need better means of understanding and predicting risk, says Robert Mittelstaedt, the dean of the W. P. Carey School.

They failed as much as the companies did. "We have to think more intelligently about how we regulate in the future," he says. Consider, for example, AIG. As an insurer, it was regulated at the state level, and its policy-writing subsidiaries faced a skein of rules in each of the 50 states. That setup is not only inefficient, but it can lead to outcomes like the present one, where the parent company landed itself in financial quicksand because no one was watching its activities.

"Nobody was really regulating the company's overall risk-taking," Mittelstaedt points out. "At some level, you've got to make sure that the assets that stand behind the viability of the company are real." As regulators and Congress try to hash out the details of the proposed bailout, they should beware of the natural tendency to make their prescriptions backward looking, he adds. "Regulation tends to be about fixing the last crisis, not anticipating the next one.

We need some kind of regulator that will look at financial risk comprehensively. Nobody wants any more government or regulation than is necessary, but companies regularly show us they are unwilling to manage risk in the broader societal interest, so as a society we need regulators who do a really great job of managing risks that people can't manage for themselves, whether it's a Hurricane Katrina or a national financial catastrophe."