Concerns with the bailout plan

The House of Representatives voted against the Emergency Stabilization Act of 2008 on Monday, repudiating the plan Congressional leaders and the White House had hoped would end the financial storm within the capital markets.

Treasury Secretary Henry Paulson’s initial bailout plan put forth September 20 proposed giving him – and his successors – sweeping powers to spend $700 billion of taxpayer money to purchase troubled mortgage-backed securities. Those securities use the value of the underlying homes as collateral.

Home values are declining as the housing price bubble deflates from its market peak in 2006.

When traders cannot readily estimate the values of the homes underlying mortgage-backed securities, then the pricing of those securities becomes almost impossible.

The market for those assets becomes gridlocked, as do those in derivatives markets for default insurance, the so-called credit swaps, which depend on accurate measurements of the original mortgage-backed securities’ valuations.

The bill presented to Congress did little to address the fundamental problems with the original Treasury proposal to subsidize investors at taxpayers’ expense and let investors whose bets went awry off the hook.

The plan never clarified the ways in which the Treasury would acquire troubled assets nor how the Treasury would dispose of them.

The bailout created a future moral hazard risk. Investors would know they would be saved from their own bad decisions if they risked too much or became too intertwined in their dealings in complicated financial instruments such as credit swaps or other derivatives.

Congress needs to pass some form of bailout legislation in the short-term to restore confidence in the markets. A final form of the bailout bill must address how the currently devalued troubled assets are to be priced and formulate proper oversight over the bailout’s management by the Treasury.

The risks assumed by traders would change as liquidity and confidence are restored to the nation’s credit markets, and by extension, to the world’s markets.

Longer term reform of the financial markets can be addressed once Congress passes some form of bailout legislation. The bill defeated Monday included calls for several studies toward this end. Regulation of derivative securities and the level of capital reserves are certainly examples of where policymakers should seek changes.

The underlying home valuation crisis also needs attention. Robert Shiller’s call for a new Home Owners’ Loan Corporation deserves special consideration. That New Deal organization oversaw the development and implementation of new forms of mortgage contracts with fixed rates and self-amortizing payments over 15 years and longer.

He argues that a modern version of the HOLC could overcome buyer resistance to new contractual terms, much as it did in the Depression era.

There is reason to believe many borrowers did not fully comprehend the implications of variable rate mortgages, particularly in a market with falling home values.

Better consumer education and additional contractual protections governing disclosures could help mitigate some of the lending practices that underlay the current subprime mortgage market meltdown.