Bailout deal nears, but will it work?

John W. Schoen Senior producer • Profile • E-mail

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.

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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.

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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.

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