What Happens Next?

When the Treasury Department's bailout plan was being debated in Congress, we did not hear very much specific language about how that $700 billion would actually be used. Whether this is because Treasury Secretary Henry Paulson did not give very many details in his testimony (either because he did not volunteer them or because those who questioned him did not press for them) or because the media neglected to report those details, figuring that they would confuse, rather than enlighten, the American public, the question remains. Now that the die has been cast, can it be answered in language that the rest of us can understand?

Leave it to the BBC NEWS Web site to inform the American public when other media do not seem to care very much. Perhaps this confuses their "home audience" even more than it does those of us who have to live with the consequences; but Gregg Wood, North America Business Correspondent for BBC News, seems to have taken the best crack at spelling out, in relatively clear language, what we can expect to happen now that the bailout bill has been passed and signed. The basic plan is simple enough to leave us wondering why we had not yet heard it: Banks with the most "toxic" assets will have the opportunity to sell them (that is, their securities backed by mortgages that have either defaulted or are at high risk of default) in a series of auctions to private buyers. Wood explains the details as follows:

One leading US investment firm said there was a very large pool of private capital available to buy distressed mortgage-related assets now that the Treasury had put a floor under the market with the bail-out deal.

If this auction process is typical, buyers will bid the price they want for the amount of mortgage-backed securities they want, and those securities will be allocated to buyers at the highest price which ensures that they're all sold.

Banks have typically marked down the price of their mortgage-backed securities to around 20% of their face value.

So for the banks to obtain any relief, the auction process will have to obtain a price higher than 20 cents on the dollar.

If no private buyers are willing to pay that price at auction, then the US Treasury will have to use taxpayers' money to pay above the market price for toxic assets in the hope that they appreciate in value over the next few years.

One would have thought that both the Senate Banking Committee and the House Financial Services Committee would have wanted to raise questions about that last sentence. In many ways an auction is a gamble on future value (not that different from commodities speculation for purposes of this discussion); but the best gamblers are the ones who can look at both the payoff and the risk with equal dispassion. Who is to say that, in a time of crisis, risk will be viewed so dispassionately? Just because there may be "a very large pool of private capital," might not those controlling that capital be more interested in risk-averse stability while they ride out the current storm, particularly when they know there is a "floor" price at which the Treasury will automatically outbid them? In other words is this really an incentive to get private interests to participate in solving a problem cause by other private interests?

So much for the details of the strategy itself. Then there are the details of the implementation of that strategy. As Wood points out, that may be where the real Devil resides:

The first is not likely to take place for at least a month.

That's because private financial firms will have to be hired to handle the process.

Up to 10 asset management companies will be used by the US Treasury.

The Treasury will also have to take on new staff to write the rules of the auction process and make sure the private firms running it don't abuse their position.

Had the Republicans heard any of this, they would have found themselves in a quandary over whether to scream "Socialism!" or scream "Big Government!" A lot of work is going to have to be done before this system can start functioning. That work is going to require a lot of expert effort, and many of those experts are going to be put on the Government payroll. Whence will those experts be recruited? Given that the Treasury Secretary himself is a Goldman Sachs veteran, it seems likely that he will be providing a new income stream for his former cronies from Wall Street. Job hunters from Main Street need not apply!

Wood concludes his report by addressing the other critical question: Once the strategy is implemented and running, how will its effectiveness be monitored? Again, this is a question that can be answered in relatively plain language:

The key indicator of whether the plan is working will be what happens to the rates the banks charge each other for borrowing money - interbank rates. They are currently sky high.

The banks don't want to lend other banks when they don't know what toxic assets they may be holding.

If the auction process helps to put a reasonable price on those assets and take them off the banks' balance sheets, then interbank rates should fall, easing up the flow of credit throughout the economy.

So it's a long and complex process. The passing of the bail-out plan is just the first stage.

And it will be several months before we can tell whether it's working or not.

Now there is nothing wrong with being cautioned that we are not going to see any results before Election Day; but this provides a good reminder of Joseph Stiglitz' attempt to take a broader view of the crisis (and the apparent reluctance of the Congress to disregard that view while deliberating over Paulson's proposal). Like it or not, there are more problems to solve than the current lack of "flow of credit." Yes, flow of credit is felt on Main Street as much as on Wall Street; but there are other Main Street problems, particularly those related to unmanageable debt, that are unlikely to be resolved by a flow-of-credit strategy (which seems to have a track record of making debt even more unmanageable). Who will be seeing to those problems between now and Election Day? Will Paulson simply tip his hat and say, "My work here is done;" thus reflecting how little our current "Denial Presidency" really feels about Main Street. Will both Houses of Congress abandon any effort to follow up on Stiglitz' analysis in favor of putting in time on the campaign trail? Even if Paulson's plan does work, Main Street will be left holding a big stinking bag, with little sign that anyone in either the Executive or Legislative Branches seems to care very much.