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Gov’t Bailout: Puzzling Out the Price

Department of the Treasury (Chip Somodevilla/Getty Images)In Washington, D.C., the battle is joined. Congress has responded to the Treasury Department's two-page bailout proposal with a slew of demands, some of which have reportedly been met. At the center of negotiations are measures for taxpayers to acquire stakes in the troubled companies, limits on executive pay, a bailout of sorts for struggling homeowners and reforms in bankruptcy laws.

But so far, the centerpiece of the administration's plan remains intact -- and how it will work remains remarkably hazy.

The Treasury Department is asking for authority to purchase as much as $700 billion in mortgage securities (and now, other assets) from financial institutions. The key question is how much the government will pay for these assets. Until today at least (both Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke are testifying on Capitol Hill today), it's a question administration officials have so far avoided answering.

One reason for that silence might be the difficulty of finding the right mechanism to value the mortgage-related assets. "The problem is people are operating in a world in which nobody knows what the hell is going on," as Bruce Bartlett, an economist in Ronald Reagan's administration, puts it.

In a piece today, the Washington Post puzzles out the possible mechanics and their associated pitfalls. The Treasury Department, for instance, has said it will use "market mechanisms where possible, such as reverse auctions." (The Post's quickie definition of a reverse auction: "the government could agree to purchase a specific amount of assets and buy those that are offered at the lowest price.") But as the Post shows, the variety of mortgage-related securities could make a market strategy perilous. By way of illustration, the reporters offer an analogy, where the most toxic subprime securities become Pintos and the more stable mortgage-related assets become BMWs:

Imagine that the market for used cars had fallen apart and the government decided to restore order by buying up thousands of vehicles. If the winning price in a reverse auction was $3,000, owners of lower-priced Ford Pintos would trade their cars in to the government, while owners of higher-priced BMWs would hold on to theirs. When the government went to sell the Pintos, it could not recoup its investment and would lose money.

But for many, how the government actually goes about buying these assets simply obscures the main reason Paulson and Bernanke haven't discussed just what the government will pay for these assets: The plan makes no sense unless the government overpays.

As the Post details, if the government were to aggressively price the assets, it might serve to weaken the financial system, rather than strengthen it. The low prices could force banks to further write down their assets. The Post's tidy summary for this state of affairs is that "the more effective the plan, the more expensive it will ultimately be."

There's a less nuanced view, however. Rather than be distracted by market mechanisms or ambiguous valuations, some think this ought to be called what it is: a giant freebie. From the New York Times:

If Mr. Paulson pays the market rate -- whatever that is -- that presumably would not be enough to persuade banks to sell. Otherwise, they would have sold already. For the plan to work, Treasury has to pay a premium.

"It's a straight subsidy to financial institutions," said Martin Baily, a former chairman of the Council of Economic Advisers in the Clinton administration, and now a senior fellow at the Brookings Institution. "You're essentially giving them money."

On the other end of the spectrum, there's Sen. Norm Coleman (R-MN), who attracted ridicule yesterday when he suggested that "the government could make 10 or 20 times what it pays on this, possibly." Only time will tell, but for now, expert opinion seems united in predicting that taxpayers will emerge from this crisis well in the red.

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