The bailout explained and what is next

After the H.R. 3997 Emergency Economic Stabilization Act of 2008, otherwise known as the $700 billion bailout bill, failed 228-205 in the House yesterday, lawmakers went back to the drawing board. Today and tomorrow there will be significant jostling as House leaders try to convince a handful of their members to vote for the bailout. Speaker Pelosi’s pre-vote speech is widely blamed for turning off several Republicans who were on the fence but planning to vote for the bill. Some believe Minority leader John Boehner can get those votes back to pass the bill in its current form on Thursday. Others believe the bill will be adjusted to add some of the provisions the Republican Study Committee (RSC) has put forth as an alternative to the bailout. Obama and McCain have backed a proposal to increase FDIC insurance from $100,000 to $250,000 to increase banking confidence. The suspension of “mark-to-market” rules, a key RSC plank, has also been discussed as an addition to the bill. So just what does the bailout amount to and what are the alternatives? The core of the plan is Secretary Paulson’s idea to buy the mortgage backed securities from financial institutions that can’t unload them due to their limited value and lack of liquidity. The Treasury would pay cash to cover the toxic debt and free up the credit markets that are at a near stand still. Financial institutions could then begin to restore their capital asset stability. Who the assets are bought from ranges from banks to credit unions to pension funds. The most likely method of purchasing these assets will be a “reverse auction.” Financial entities will offer the securities they don’t want at a certain price and the Treasury will then assess what has been offered and start by buy the least expensive securities first. This would create an incentive for firms to price low enough to be bought, but not so low that they don’t benefit from the sale and hopefully limit the Treasury overpaying for the securities. Specifically, here’s what the failed bailout would have done: 1. Create the “Financial Stability Oversight Board” or FSOB as a new agency to manage the bailout

This board would consist of the Treasury Secretary, the Housing and Urban Development secretary, the chairman of the Fed, the chairman of the SEC, and the Federal Home Finance Agency director
This board would be charged with “ensuring the policies implemented protect taxpayers and are in the economic interests of the US”
A separate congressional oversight panel would also be established to review the state of the economy and the FSOB’s activities
The Treasury would retain decision rights over which assets would be purchased and the day-to-day operations of the bailout
2. Increase the national debt limit another $700 billion
The Treasury would be granted powers to spend “up to” $700 billion as they see necessary
Only $250 billion would be made available for purchasing troubled assets
The President’s office would have the authority to release another $100 billion at its discretion
The Treasury would have to request the additional $350 billion in writing if it believes the money is necessary
The Treasury would only have authority to purchase securities that originated on or before March 14, 2008
Authority to spend money in this manner would expire Dec. 31, 2009
3. Charge the Treasury to push for wide-sweeping mortgage refinancing to avoid foreclosures and adjust the mortgages it buys
The bill asks the Treasury to exert it’s new influence as a major mortgage securities owner on financial institutions to modify the trouble loans it does not sell
The Treasury would create a plan that “seeks to maximize assistance to homeowners” by adjusting and refinancing mortgages that it now owns
(A complication with this is that banks often times only own portions of a mortgage and not all the securities issues for that mortgage making it impossible to refinance the mortgage, the government will have to ensure it buys all the securities issued on a particular mortgage in order to adjust it)
4. Protect taxpayers from risk
The Treasury would buy assets that have underlying value that is currently not being realized due to market conditions and mark-to-market accounting rules
The Treasury would hold on to the MBS assets it buys until they regain value and potentially a profit by selling them back to the open market, covering the $700 billion spent to buy them
The President would create a plan to “recoup money form the financial industry” if the assets do not regain value and result in a net loss for taxpayers within five years of purchase
The Treasury would also acquire “nonvoting common stock or preferred stock” in firms participating the program to give taxpayers an ownership stake in the companies it is bailout out and a share of money in case the firm goes bankrupt
5. Limit the compensation packages of corporate executives
Any company that participates in the bailout would not be able to pay a salary above $500,000 to its top five executives
Companies that sell the Treasury more than $300 million of assets would not be allowed to write new “golden parachute” packages for their executives during the duration of the program
Companies would have to “claw back” past bonuses issued to executives that were based on misleading financial statements
Existing compensation packages contractually agreed to would not be adjusted except for cases of fraud
6. Create an insurance program for mortgage backed securities
The Treasury would establish and insurance program to guarantee financial firms’ troubled assets, including mortgage backed securities, “up to 100%”
Risk-based premiums would be paid by the firms whose assets are being protected
Any insurance claims would be paid out of the $700 billion allocated for Treasury expense on the program
This would give the mortgage backed securities greater value and increase their desirability in the marketplace
Republican leaders didn’t want the executive compensation limits or provisions to protect taxpayers in the bill, but they yielded in exchange for leaving out Democratic ideas to let bankruptcy judges alter the terms of mortgages and to give cash to struggling homeowners facing foreclosure. The Republican Study Committee has proposed a separate plan, though Democratic leaders have not brought it to the floor. This plan would create a “work-out” program instead of the $700 billion bailout program (some provisions were included to make the plan palatable to Democrats as a compromise move): 1. Suspend capital gains taxes for two years
This would immediately suspend the capital gains rate from 15% for individuals and 35% for corporations
This would encouraging corporations to sell unwanted assets, unleashing funds and materials with which to create jobs and grow the economy
After the two-year suspension, capital gains rates would return to present levels but assets would be indexed permanently for any inflationary gains
2. Repatriate profits from U.S. firms overseas
This would create a repatriation window for American firm’s to bring their overseas profits into the U.S. tax free if invested in troubled mortgage backed securities for at least one year
The Treasury would have to define, manage, approve these sales
3. Provide immediate capital by generating a tax refund for net operating losses
This would allow companies to “carry-back” losses incurred in 2007-2009 five years and receive a tax refund for those losses
This carry-back would provide a cushion for any losses firms take by selling the mortgage backed securities they have at the huge loss they would receive in the current market
This would give MBSs immediate value
4. Suspend “mark-to-market” accounting rules
This would suspend the mark-to-market regulatory rules until the SEC can issue new guidelines that will allow firms to mark these assets to their true economic value
5. Stabilize the dollar
This would repeal the Humphrey-Hawkins Full Employment Act which diverts the Federal Reserve’s attention from long-term price stability to short-term economic growth
This would require the Fed to establish a numerical definition for price stability and maintain a policy that promotes it over the long-term
This mandate has encouraged the Fed to keep rates artificially low, fueling economic boom and busts, and now a strong up-tick in inflation and the decline of the dollar (as investors free dollars for hard assets)
6. Schedule Fannie Mae and Freddie Mac for privatization
This would require the Treasury to “truly” privatize the GSE firms over a reasonable time period and strip them of all special government privileges
This would also require the GSEs to pay an appropriate risk-based fee for the current government guarantees that act as insurance for them, subject them to state and local taxes, and force them to file with the SEC like all other for-profit firms
The Treasury would be charged with ensuring Fannie and Freddie no longer securitize any unsound mortgages and limit federal backing for high risk loans
7. Limit the compensation packages of corporate executives
The Treasury would be required to write rules prohibiting “excessive compensation or golden parachutes to executives of failed companies” if they come at the expense of taxpayers
8. Create an insurance program for mortgage backed securities
This is the same as the insurance provision included in the bailout bill