The Bailout Plan: Will it Work?

By Katalina M. Bianco, Law Analyst, Wolters Kluwer Banking and Finance Group

Congressional leaders and the White House announced on September 28 that they had reached a tentative agreement on the $700 billion rescue program dubbed the “bailout plan” by the popular media. The plan is expected to go to the House for a vote on Monday, September 29.

As Congressional leaders prepare to sell their colleagues on the plan, questions as to the plan’s viability remain. Few experts doubt that decisive action by the government is necessary to restoring confidence in the credit markets, but economists and analysts are split on whether the plan will have the desired effect of righting the economy.

The extraordinary decline in the housing market has increasingly devalued financial institutions’ trillions in mortgage-related securities. As the value of those assets drops, losses have decreased the capital available to cover them, making it difficult for banks to lend.

Critics of the plan have identified what they see as problems with the plan. One of these problems is that if the government pays current prices for the securities in the current depressed market, selling firms may experience sever losses, leaving them vulnerable to the fate of such financial giants as Lehman Brothers and Goldman Sachs. However, critics reason that should the government pay too high a price for the securities, any benefits that taxpayers may expect would be lessened.

Allowing companies to get rid of their portfolios of failing mortgage securities under the plan would halt the current decline and make them more attractive to investors, providing them with the capital necessary to go about the business of lending. The problem, critics argue, is that the complexity of the mortgage securities market could work against this capital transfer.

The typical mortgage-backed security is a trust containing a portfolio of thousands of individual mortgages merged to create a specific risk profile. It offers investors a stream of payments (based on the underlying mortgage payments) at a given yield.

A single trust might be further blended to construct different derivative securities, each one subordinated to the next in terms of the claim on cash flow. Should a default occur, the highest-rated, and lowest-yielding, security has the priority claim to the remaining mortgage payments. The next-highest-rated security has the next claim and so on. As the market grew, underwriters got more creative in their construction. Risk went up and in many cases loan quality went down. When the real-estate market disintegrated, defaults rose, undermining values, and trading slowed until determining actual value, always difficult with mortgage-backed paper, became almost impossible.