Jeremy Siegel, Ph.D. The Future for Investors

On Friday, President Bush signed into law the Paulson plan, which aims to jumpstart a financial system that has virtually been shut down by the deepening mortgage crisis. Although there are some attractive aspects of the plan, Treasury Secretary Henry Paulson bungled its marketing big time.

Paulson introduced his proposal with an imperious demand: $700 billion with no Congressional oversight! And then he did not discourage the use of the word "bailout" when, if structured properly, the Treasury plan could net the government a nice profit instead of bailing out Wall Street.

But all of this is water over the dam. Now that Congress has approved the plan, here's my take on the good and the bad.

Bailout

The Paulson plan need not become a wholesale bailout of troubled financial institutions. It is possible that the plan can be a "win" for both taxpayers and banks. One of the central tenets of economics is that a trade often involves gains to both parties and this is no exception.

The collapse of the housing market has sharply lowered the price of real estate, so many of the mortgages and securities issued against homes are now "under water," or worth less than the value of the house. If a lender wrote a $300,000 mortgage on a house that is now worth only $150,000, the "intrinsic" or underlying value of the loan is now 50 cents on the dollar. Although some states allow the lender to go after the borrower's non-real estate assets to satisfy the mortgage payments, in practice lenders take possession of the home, even if it is worth less than the loan value.

But in these stressed times, the lot for mortgage lenders is even worse. Because of the current illiquidity of the mortgage-backed security markets and the confusion of ownership rights of some of these complex securities, investors are willing to pay only 30 cents on the dollar or less for an asset with a 50 cent intrinsic value. It is in this situation where the government has an opportunity to improve the lot of the buyer and seller. The Treasury has the ability to hold these assets until the mortgage is restructured in order to realize the intrinsic value of the loan.

This does not mean a recovery of 100 cents on the dollar, but, if the government can buy the loan for 40 cents, it can still receive a good return on the investment if prices eventually rise to only 50 cents. In the meantime, the financial institution has swapped a distressed asset for a highly liquid security. Treasury bonds can count towards the capital that the bank must have in order to start lending again.

The best way for the government to sell Treasury bonds in exchange for the banks' distressed assets is to run a "reverse auction." The Treasury announces that it is willing to buy a certain amount of mortgage-related securities and asks financial institutions to submit a sealed bid for the price and the amount of the distressed securities that they are willing to sell.

Those institutions that offer the lowest prices for their securities will obtain Treasury bonds in exchange. The government must specify a minimum quality of such mortgages (such as delinquency status, credit ratings for borrowers, etc.) so that it does not end up with only the worst loans. Experts, such as Bill Gross of PIMCO, have offered their services to help the government formulate these auctions.

Recovery for Taxpayer

Of course it is likely that the government will still overpay for some of these assets. This would happen if the housing market continues to deteriorate or the price asked by the financial institutions for their distressed loans exceeds their intrinsic value. But the government can also recover its costs by taking ownership claims in the institutions that participate in rescue process. In fact the legislation requires the Treasury to acquire such ownership claims if the government takes total control of the institution or offers it a large loan, such as it did for AIG.

If in spite of all these actions, the government after five years does not recover the value of the money that it lent, then the President is required to submit a legislative proposal to recoup such funds from program beneficiaries. This can take the form of a surtax on the regular corporate tax, or the issuance of new rights to buy common shares at a discount.

Of course, despite all these protections, it is possible the taxpayer will end up footing part of the bill. But this is not the worst outcome. The primary source of government tax revenue is from the income and corporate profits tax. If the plan had not been adopted, the recession we are in would become worse and government tax revenue would fall. Furthermore, on the day the House first rejected the plan, US stock market values fell a whopping $1.2 trillion, which is almost twice the total cost of the plan even if the government doesn't recover anything from its program.

Summary

Very few are happy that the government has to resort to such a program to shore up the economy. In another column I will talk about how we got into the mess, but given where we are, the plan is a sensible attempt to liquefy the banking system and stimulate the economy. The world would not have collapsed if the House didn't pass this measure, but, if designed and executed properly, this program can be a plus for the financial institutions, the economy and the taxpayer.