Lawmakers raised doubts Monday about what would be the largest government bailout in American history, but a bigger, more terrifying question lurked right under the surface: What if it doesnt work?
Failure, says one insider, is not an option.
The alternative is complete financial Armageddon and a great depression, said a former Federal Reserve official. Where do they go after this? Well, the U.S. government could nationalize the banking system outright.
A few months ago, that idea would have been laughed out of the room.
But no ones laughing anymore.
While almost no one wants to dwell publicly on the possibility that a $700 billion package could simply be too small to forestall a financial meltdown, privately some aides were already thinking of what the government might do if the Treasury plan passes but fails.
In a statement Monday, President Bush said that the whole world is watching to see if we can act quickly to shore up our markets and prevent damage to our capital markets, businesses, our housing sector and retirement accounts.
What the president didnt say is that the whole world will be watching to see not just if Washington can act but whether Washingtons actions can still make a difference.
Under the current plan, the U.S. government will buy up to $700 billion in assets from private holders on Wall Street. That would help banks stabilize their balance sheets, and in theory provide an incentive for banks to begin extending credit among themselves again a critical component of a functional financial system.
So whats Plan B?
There really isnt one.
If this weeks bailout doesnt work, the government will probably have no choice but to continue to buy assets. Theres no one left to pick up the tab. The private sector got us into this mess, said House Financial Services Committee Chairman Barney Frank (D-Mass.). The government has to get us out of it.
Getting us out of it would likely mean buying up even more debt in the markets if the $700 billion fails to turn things around. That could include credit card debt, which is securitized and sold on Wall Street the same way as home mortgages, car loan debt and even commercial real estate debt, until the problem begins to recede or the taxpayers gain effective control over the nations banking system.
So how will leaders know whether its working or not?
Traders and Washington insiders will look at credit market indicators to gauge their progress. One number in particular will be the focus of enormous attention on the day the bill passes: the difference between the interest rate offered by the federal government and the rates private banks charge when they loan money to one another.
If confidence is returning to the credit markets, the spread between the two numbers should begin to narrow as the banks rate known by the acronym LIBOR falls. But if the credit market is still in distress, the spread will widen.
In theory, traders should be able to see the results of any congressional legislation within minutes of news of the bills passage hitting Wall Street.
Heres the good news: Already, just based on the news that Treasury is working on the proposal, the spread has been narrowing this week, down from the dramatic highs of last week. That means the market is pricing in an expectation that Congress will act and that the action will work.
If everything goes smoothly, it is even possible that taxpayers will profit from the deal in the long run, as the underlying assets accumulate value over the coming years and the government is able to ultimately sell them back into the market at higher prices than its paying now. Of course, its also possible that the values will never come back, in which case taxpayers would be on the hook.
The specific details of the package were a moving target on Monday, and congressional Democrats tangled with administration Republicans over the exact makeup of the bill.
Said Senate Banking Committee Chairman Chris Dodd (D-Conn.): The last thing any of us want is to be back here in a month coming up with some new plan because this didnt work. Its important that we act quickly, but its more important that we act responsibly.
Thats congressional code for: Hey, wait a minute.
The Banking Committees ranking Republican was of a similar mindset. I am concerned that Treasurys proposal is neither workable nor comprehensive, despite its enormous price tag, said Sen. Richard Shelby of Alabama. In my judgment, it would be foolish to waste massive sums of taxpayer funds testing an idea that has been hastily crafted and may actually cause the government to revert to an inadequate strategy of ad hoc bailouts.
Ultimately, the negotiations will come down to doling out huge new powers, including:
Buying Power: This is the cornerstone of the proposal allowing Treasury to buy up to $700 billion of privately held assets in the market. The original proposal called for buying power to be limited to mortgage-related assets, but a later draft expanded that to allow the government to purchase any troubled assets. Theres a staggering difference in authority between the two phrases, and it is a moving target as of press time. The banking industry generally favors the second version, but that potentially exposes taxpayers to much higher costs.
Managing Power: Under the Bush administrations plan, Treasury would hire private managers to handle the hundreds of billions of dollars worth of assets it will soon own. But Treasury was silent on whether those managers would be able to actually negotiate directly with homeowners who hold the troubled mortgages. Democrats would go further and demand that bankruptcy judges be given the ability to renegotiate those failing mortgages on behalf of homeowners. This will be one of the more contentious sideshow fights of the negotiations.
Global Power: Under one version of Treasurys proposal, the government would have the power to buy assets from any institution in the world that it deemed worthy of a bailout.
Pay Power: Democrats on Capitol Hill say they want the final plan to include restrictions on payouts to the executives of the financial institutions that take the taxpayer lifeline. Paulson says he doesnt like this idea, but it may be tough for elected officials to oppose this populist carve-out in an election year.
Equity Power: Democrats would like the government to get shares in the financial institutions that take federal help effectively giving taxpayers ownership stakes in the nations largest banks and providing them with a huge windfall if those institutions prosper in future years.
Oversight Power: Treasurys initial proposal included very little room for congressional oversight of the new effort, calling for reports to be sent to the Hill just twice per year. That isnt flying with Democrats or many Republicans on the Hill; if a bill makes it through Congress, it will almost certainly have much stronger oversight provisions.
