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Bailout deal nears, but will it work?

After a frantic week of negotiations, Congress and the White House are nearing agreement on a plan to quell the panic gripping the credit market. But will it work?
Image: Members of congress
Members of Congress meet to discuss the bailout plan on Capitol Hill on Thursday.Susan Walsh / AP
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After a frantic week of negotiations,  Congress and the White House are nearing agreement on a plan to quell the panic gripping the credit market. A congressman involved in the talks said Thursday morning that “the cavalry has arrived.” The big question now is whether they’ve brought enough bullets.

Here’s a look at the broad outlines of the plan — and what it’s supposed to do:

What’s in the plan? How is it supposed to work?
The core of the plan is the funding of what amounts to a $700 billion, government-run hedge fund that will buy up bad mortgage-backed debts from banks and other financial institutions, allowing them to raise cash and get money moving through the system again.

Since no one wants to buy these bad debts, no one knows how much they’re really worth. That uncertainty was part of the reason Fannie Mae, Freddie Mac and insurance giant AIG had to be rescued this month.

The hope is that if the government steps in as a buyer of mortgage-related securities, that demand will help everyone put a price on these assets and remove fears that more companies holding these bad debts will go under.

The government’s going to run a hedge fund?!? They can’t even balance the budget! Who’s going to manage this thing?
That’s still unclear. Early on, some members of Congress wanted to set up a separate entity —like the Resolution Trust Corp. that cleaned up the savings and loan mess in the 1980s. But that plan was abandoned as the market meltdown deepened because it would take too long to set up a new agency.

The Treasury will likely manage the overall buying and selling of bad debts. It already handles multibillion-dollar auctions of Treasury debt. Treasury Secretary Hank Paulson said private Wall Street firms might be hired to handle the some of the analysis of which debt to buy. Chairman Rep. Barney Frank, chairman of the House Financial Services Committee, has suggested that the New York Federal Reserve — which also buys and sells billions in debt securities every day — might be tapped to manage the fund’s operations.

So how will the government figure out how much to pay for these bad debts?
That's the $700 billion question.

Details are still being worked out, but the most likely scenario involves a kind of “reverse” auction. When the Treasury sells new bonds, it takes bids and sells what it needs to whoever agrees to take the lowest interest rate. As a buyer of bad mortgage-backed paper, the Treasury would want to buy the cheapest paper first. Once investors in the credit market see these bad debts changing hands at real prices, the hope is that market demand for this paper will improve.

What could go wrong?
It’s still not clear that an auction system will assign a true value to these securities. Since they’re backed by mortgages, a lot depends on how many more families default on their loans.

This paper is almost certainly worth something: Ultimately it's backed by houses, which have some value. But if the government buys mortgage-backed securities now, and home prices keep falling, it could wind up overpaying, with taxpayers picking up the tab.

There’s another risk. Banks holding these securities have to mark down their value on their books based on market prices. So far, since there is no market for this paper, they had to guess what it's worth. Some banks have marked the securities down further than others.

If the market price established by the government turns out to be lower than the price banks are using to value their holdings, those banks are going to have write them down further. That would mean another wave of writedowns and losses for a banking industry that’s already on the ropes.

How much is this going to cost me?
No one knows. The plan is for the government to hold on to these mortgage-back securities until the economy and housing market improve, and then sell them — possibly for a profit. Banks that sell their bad debts into this plan may also have to give stock to the Treasury. As the crisis subsides, and banks get back on their feet, that stock could also be a winning investment for the government.

But if the housing market keeps falling and mortgage defaults keep rising, the government may wind up on the losing side of the trade. The latest housing data, released Thursday, shows home prices fell much further than expected in August. Until the housing market stabilizes, and home prices stop falling, buying mortgage-backed securities is a risky bet.

But the government is now the investor of last resort.

Do we really need to do this? My ATM machine is still working. Isn’t the government just scaring us into bailing out Wall Street?
The effects of the credit freeze haven’t yet fully worked their way through the system to consumers, though there are early signs that’s it's doing so. Some banks have begun canceling home equity lines of credit. Private lenders have been fleeing the student loan market.

One way to think about the crisis: The economy is like a patient who was just diagnosed with clogged coronary arteries. The patient feels fine and might continue to feel fine for days,  weeks or even months. But without treatment, he’s at grave risk of a heart attack. So think of the government’s plan as a kind of financial bypass surgery — to restore the flow of capital through the economy. The treatment is not without risks, but the risks of doing nothing are much greater.

What about the homeowners stuck with these bad mortgages: Are they getting help too? Or is this just a bailout for Wall Street?
This was one of the biggest objections to the Treasury’s original proposal; Paulson told Congress that once the government buys up mortgage-backed paper, it may be easier to work out better loan terms with homeowners at risk of default. That's a big maybe.

Congressional Democrats countered with a proposal they’ve been pushing for the past year: Give bankruptcy court judges the authority to set more affordable loan terms, and cut through the red tape that has slowed voluntary efforts to get lenders to renegotiate bad loans with ruinous terms. The White House has been dead set against the idea, saying it would make new mortgages harder to get. At this point, the White House appears to be prevailing.

How about the CEOs in charge of the banks that got us into this mess? Are they going to get to keep their millions in salaries and bonuses?
Congress also made clear this week that their constituents would squawk loudly if Wall Street executives walked away from this mess without suffering the consequences of the failed bets their companies made. To be sure, some of those executives already have lost millions in personal wealth as stock holdings in their companies have plummeted in value.

Congressional leaders have insisted on capping the pay packages for CEOs of companies that will benefit from the plan. But it’s far from clear how that will work: Many CEO pay packages include forms of deferred compensation that, if structured to work  around the new law, could wind up being sheltered over the long term.

So this will keep the economy from getting worse, right?
If the plan works, the hope is that it will minimize the economic damage from the current financial panic. But even before the credit market began to freeze up this month, most forecasters were expecting the economy to get worse before it gets better. Unemployment is rising and home prices are falling. The recent shock to the financial system has spilled over to the wider economy, but there’s a lag as that impact moves through the economy. Even if it doesn’t spread further, the damage won’t be known for some months to come.

No matter how well the bailout works, the age of easy-money lending is over. Consumers who have been accustomed to borrowing to pay bills will have to tighten their belts. Small businesses may have a harder time getting loans. If foreign investors lose their appetite for Treasury securities — including the latest serving of $700 billion in fresh debt — Uncle Sam will have to pay higher rates to sell bonds. Until lenders' fears subside, tight money will continue to be a drag on economic growth.

What if it doesn’t work?
The plan is still very fluid, and Congress and the White House will likely continue to work on broader solutions in the coming months. The main concern is that financial markets move a lot more quickly than Congress. That’s why the Treasury initially asked for broad powers to act quickly.

If the plan doesn’t free up the flow of money, companies won’t be able to get the short-term loans they need to smooth out the seasonal ups and downs of their cash flow. If they run out of cash, they could be forced out of business. If mortgage lending gets tighter, the housing market will take longer to recover. If the money freeze continues, consumer credit like car loans could become harder to get and more expensive when approved. If consumer spending slows further, that drags the economy down with it.

We may not know for awhile whether the plan is working. Over the short term, if key interest rates come down, that’s a sign that confidence is returning to the markets. But because most of the bad debt clogging the system is hidden from view, it will be months — at least — before the economy and financial markets will flash the “all clear” signal.