Finally, a plan

Each of the past few days I sat down to write about the bailout plan, the details of the plan changed. We can chalk that up to politics, but in this instance, I think the end result was better than the original framework. Details are still sketchy, but reports are that the plan limits compensation and gives the government rights to buy stock in participating firms. These features help contain the moral hazard problem. By limiting pay, the message sent is essentially "if you manage a financial firm in a way that you need government help, you aren't going to get the compensation you hoped for." The right to buy stock in the firm is an even more important feature. It allows the government, and by extention the taxpayer, to profit from the firms' recovery while diluting the existing shareholders. Again, if the firm needs saving, the shareholders are going to have to share the eventual upside and not reap all the benefits. These two features of the plan go far towards preventing the "privatize profits, socialize losses" thinking you heard so often these past weeks.Speaking of losses, there is good reason to believe this plan shouldn't be considered a huge "bailout" as it has been called. First, $700 billion is not being "spent" as it would in a tax cut or health plan. Rather it is being used to finance the purchase of assets. In fact, it probably shouldn't be considered taxpayer money as much as use of taxpayer's credit. What's the difference? The Treasury is going to borrow these funds by issuing more debt. It is able to do so because U.S. government securities are considered the safest "paper" in the world. These funds will be borrowed at a cost of around 3-4% per year. Isn't the interest a taxpayer expense? It is except the securities being purchased yield over 10%, which means the Treasury is going to earn the 7% or so per year difference. It remains a bailout in principle, not necessarily principal.

What about those losses, how big will they be? Obviously this is extremely difficult to predict. Consider that many of these "toxic" assets are being valued at levels many think are too low. When everyone is afraid of buying a security, the only trades that will occur are at absolutely distressed levels. Low prices provides real value to the buyer as the lower one purchases an asset, the more room for error in absorbing any losses.

The low prices also provide an opportunity to really help the situation. For example, say two neighbors on your street get foreclosed on and the banks want out quick, so they sell those homes at auction for 65% of what you paid for the identical house. Now say you want to refinance your loan and try get an appraisal. The only two recent transactions for comparison are at distressed fire-sale prices of 65%. You can't refinance your house since your loan is for 80% of the value and no one is going to lend more than the appraised value. This is how "mark to market" accounting works. Banks must record an asset's value at the last trade and if that trade is obscenely low, the bank takes a paper loss and needs to raise capital.

Here is a bit of hidden genius in the Treasury's plan pointed out to me by a veteran Wall St trader, Terry. If the Treasury is the only real buyer of such securities, it will "set the price" meaning that the last trade will not be an obscenely low distressed sale but instead will be something much closer to actual value. The immediate impact of this will help banks stabilize their balance sheets and possibly result in less of a need for the bailout.

The plan must still pass Congress and could be changed yet again. It still doesn't entirely solve the problem of bank capitalization and falling home prices, yet it should stop the panic. As the credit markets unfreeze, we only have to worry about how to deal with the recession. Hey, I'll take that over a meltdown anyday.

Hopefully, crisis conditions will subside shortly and we can again focus on a variety of financial topics. We received a few great email questions in the past week or two and I hope to tackle those shortly. Keep the questions coming.