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M.P. Narayanan
  M.P. Narayanan
 

Congress Passes the Bailout -- Now What?

10/6/2008 --

Ross professor says plan can kick-start stalled lending.

ANN ARBOR, Mich.—Wall Street is breathing a collective but qualified sigh of relief this week after the House of Representatives on Friday passed an amended version of the $700 billion ďbailoutĒ package they originally rejected. The revised package, passed by the Senate Oct. 1, includes tax breaks and an increase in bank deposit insurance limits, but keeps the essence of the bill intact. It allows the Department of Treasury to buy troubled securities, providing the market with much-needed liquidity. Opposition from Main Street continues, despite arguments by leading economists that the rescue is needed to save the nationís system from a severe downturn. Professor M.P. Narayanan, chair of the finance area at Ross, says the bailout is needed because Wall Street's problem is Main Street's problem. In the following Q&A, he lays out how the process should work and what moves are needed after the markets stabilize.

Listen to a podcast featuring M.P. Narayanan.

Will this plan, as designed, really help the economy?
Narayanan: Some sort of a bailout is necessary. And the reason I think that is because there is so little liquidity in the market today. Companies and financial institutions that have all of these securities are unable to sell them at what might have been, in a normal market, the right price. If you're holding mortgage securities with a face value of $100, in a normal liquid market they may be worth considerably more than the $20 or $30 they're getting. In today's market nobody wants to touch any of these. There are no buyers. So a government plan that creates some liquidity so that these mortgage securities can be priced -- if not at, then close to, their fair price -- would be a good thing. That way the market will start to be more efficient, there will be more liquidity in the market, and we'll see the credit squeeze kind of lighten up. That has a spillover into the real sector where the jobs, productivity, and all those issues come in. With expensive credit, or no credit, companies are not going to invest as much and that will only make the unemployment situation worse, which in turn would lead us into a possible recession. Even with a bailout we may enter into a recession. But to me, with no bailout of any kind, to me it looks like we are courting disaster.

So what are the stakes here, for both Wall Street and Main Street?
Narayanan: I think they are intertwined, but let's start with Wall Street. In the case of Wall Street -- commercial banks, investment banks, insurance companies, and financial firms -- clearly their survival is an issue right now. If the economy continues to go where it is, you are likely to see some more failures. But the problem is because of this fear and uncertainty, if the commercial banks or the financial institutions are not willing to invest or lend, then that has a really bad spillover effect onto Main Street. Then companies will invest less because the cost of money goes up. If you invest less, we are going to see unemployment rise and consumer spending go down. So yes, these are interconnected. Thatís why I think Treasury is stepping in. They're not stepping in to save some Wall Street guys.

So Treasury wants to buy these securities, hold them, and sell them when the market is right. What are the implications for the federal government and the taxpayers?
Narayanan: From a purely economic perspective, they are paying cash for an asset and holding it. So their cash goes down when they pay for it, but it has been replaced by an asset whose value may or may not equal the cash that they paid. But they are on the hook only for the difference between the cash that they paid and the value of the asset. And it's likely the value of the asset may end up being greater than the cash that they paid. Then you have a surplus, not a deficit, in an economic sense. I don't know about the federal accounting standards. The question is: What is the delta, the difference between the cash the government will pay and the asset they will get? It may not be anywhere close to $700 billion. But at this point in time, we don't know.

The key is how they set it up. We need to set it up right. If the government is the only buyer, then the odds are probably high that the government will overpay. The devil is always in the details. What they can do is set up a way where there is a competitive market for these securities. The problem right now is that there is no market. So the government can artificially create a market where some sort of a fair price will come up. One can think of various mechanisms where the exposure to the taxpayer is limited, or the taxpayer can come out ahead. But nobody knows what the fair value is for these assets because there is no market right now.

Also, if a firm sells enough to the government in the auction process, the government will hold some equity in that company. The government actually would be holding warrants. So if those equity values go up, the price of the warrants would go up and the taxpayers would make out.

Why do you think there has been so much opposition to the idea?
Narayanan: People seem to think that this bailout is like a dole given to these companies. It's not clear to me that it is. It may end up being so; that we cannot predict. But the intent is clearly not to do that. The taxpayers are making a calculated bet. That doesn't mean that we will not lose. But it doesn't mean that we are just handing out money. The opposition has been a little bit surprising, but clearly, lawmakers are worried about their own House or Senate seats, and they're worried because it's unpopular. That is a little bit of a puzzle to me. I think what I hear from economists is that we need to do this right, not that we shouldn't do this at all. But the way it's presented, the very word "bailout" has this implication that it is some kind of dole to the Wall Street guys who got us into this mess. But the intent is not to bail them out. If we're going to use the world bailout, who are we bailing out? I think we are bailing out the economy. That's what the goal is.

The bill, as proposed, would give the Secretary of the Treasury a lot of discretion on what to buy and whom to but it from. Is that a legitimate concern?
Narayanan: That is a legitimate concern. And the concern isn't about the person there now getting that power; it's the institution, the office. When you give government employees that kind of authority, there is definitely a chance for it to be misused. There's a chance we might end up overpaying for some of these assets. And I think it was proper for Congress to inquire about that. Ultimately the issue is about the price. How much would you pay? With the bill as it was written, Treasury has 45 days to come up with a process. The more market-oriented, the more competitive the process is, the more likely it is we won't end up paying more than the fair price. The government is going to hire asset managers. One proposal I saw would have multiple asset managers bidding. Each asset manager can be given a certain amount of money, and then you are creating a market of sorts. And you should reward those people based on how much money they make for the government. You cannot have a competitive setup without the proper incentives for these asset managers. You have to set it up so they have the taxpayer interest at heart.

This bill would seem to be first step on a longer road. Now that a rescue plan has been passed, what are the next steps?
Narayanan: You have to ask what got us into this mess in the first place. What can we do to make sure that the probability of something like this happening again will be lowered? Some sort of oversight is probably necessary. I donít' know if there's a last word yet on this, but at this point it looks like the problem started in the mortgage securitization model. That's where a bank makes a loan and sells it off to somebody. So the bank is not holding the loan, the originator does not hold the loan. And it's a good thing. There are good things that come out of it. By not depending on the originator to hold the loan, we are allowing money to flow where it is needed and we thereby benefit by getting low interest rates. But the problem is that if you are not going to hold the loan, then your incentive is to originate it and not worry about how good the loan is. So can we fix some of those issues so we won't run into the same subprime mess? People took loans that should not have been given. How can we set up some structures that will make the securitization model work better? I donít' think it's a good idea doing away with the securitization model. Then we go back to local banks lending to local people and I don't think that is a good thing at all. Then, depending on what happens over the next six months, if we get into a recession, we have to figure out how to boost consumer confidence.

—Terry Kosdrosky

For more information, contact:
Bernie DeGroat, (734) 936-1015 or 647-1847, bernied@umich.edu