IU professors predict bailout bill aftermath

As the credit crunch worsens and people continue to lose confidence in the stock market and the economy as a whole, a controversial saving grace appeared for the affected financial institutions Friday in the form of a 263-171 vote in the House of Representatives.

Though IU professors know the $700 billion bailout plan passed by both the House and the Senate will involve intervention into private financial institutions such as banks and lenders, they are unsure of the impact it will have on the country.

These loans will remove what clinical associate professor of business economics and public policy Andreas Hauskrecht called “toxic assets” – those assets financial institutions had in their portfolios that failed in the market, such as real estate loans and stocks.

“If the plan works how they think it will work, then the negative impact from the financial sector problems on the real sector will be smaller,” Hauskrecht said. “In other words, the recession, if we get one, will be not as bad and probably shorter.”

However, Hauskrecht also said this bill is laced with several problems.

“If the price that this fund offers to buy those assets is too low then those financial institutions are not willing to sell them, because if they sell it too low, they have to realize it in their balance sheets and they have to write off too much,” Hauskrecht said.
“If the fund buys those toxic assets at a high price, then the risk that this fund will end up with huge losses that the taxpayer has to come up with will be very big.”

The fund is paid for by taxpayer dollars, and the banks are trying to capitalize on the situation in order to compensate for the losses they developed through their holdings of toxic assets, Hauskrecht said. In looking at the situation, banks might see an advantage in trying to sell high in order to get rid of their toxic assets at a higher price than they got them for, thus gaining from their losses rather than suffering from them.

However, this problem is resolvable, Hauskrecht said.

“One way to deal with the incentive problem will be that the fund, by buying toxic assets from those institutions, gets some preferred stock in exchange,” he said. “In other words, the fund will benefit from an increase in the stock value of those institutions, and therefore the taxpayer will benefit from that.”

This bill could have several positive results, said professor of finance Bob Jennings.

“Banks are getting very unwilling to lend to each other and lend to businesses and individuals,” he said. “If the government can establish a market for these securities (toxic assets) and get some of these securities off the books of the banks that are holding them, then the banks will in fact resume more normal lending. That will allow the businesses to continue in business and will allow consumers to continue to borrow.”

However, as far as incentives go, it could also have negative effects.

The idea among many economists, Hauskrecht said, is that this bailout is what’s called a “moral hazard,” meaning it is setting a precedent for allowing institutions to fail and then rescue them once things get messy. Setting such a precedent could give banks more of an incentive to delve into riskier prospects of lending and other activities in the hopes of making money with the federal government behind them to catch them if they fall.

Whatever way the bill shapes up, Hauskrecht said, it is the job of the next president to make certain the economy gets back on track. In fact, he said he believes the measure of the next president’s success will be his ability to deal with the onset of this economic crisis and with the biggest problems in this country – Medicare and social security – in economic terms. However, there might be little hope on this front.

“Given the budget situation, the next administration is paralyzed,” Hauskrecht said. “They will not have the funding or the resources to tackle the two biggest problems that we have. I could be cynical and say it doesn’t matter who becomes president anyway because they will spend the next three to five years cleaning up this crisis, and that’s the real tragedy behind it.”