Taxpayers on the Hook: How to Make a Bad Bailout Better

Treasury Secretary Paulson and Fed Chairman Bernanke return to Capitol Hill today to make the case for their $700 billion bailout.

Bernanke warned of "grave threats" to the economy in prepared testimony before the Joint Economic Committee this morning; he and Paulson are scheduled to appear together before the House Banking Committee at 2:30 p.m. ET. (The House hearing should make yesterday's contentious Senate hearing look like a fancy tea party.)

Taxpayers and congressman alike are right to be outraged if the government really is going to buy distressed debt via reverse auctions -- and at prices above their current "fire sale level," as Bernanke suggested yesterday.

"If that's all you say, you're going to get the garbage of the garbage" when it comes time for the auction, says Lawrence White, economics professor at NYU's Stern School. "Sellers who know more about the quality of what they're trying to sell are going to do in the buyer."

In technical terms, that's known as "adverse selection."

In layman's terms, it's called "the taxpayer getting hosed."

White, a former board member of the Federal Home Loan Bank and a member of President Carter's Council of Economic Advisers, says there are steps the government can (and should) take to limit risk to the taxpayer, assuming some plan is approved (as Warren Buffett seems to think):

• Specify in great detail what kind of mortgages are eligible for the auction, using parameters such as origination date, location and FICO scores.
• Provide higher bids for securities backed by "better" mortgages and lower bids with worse ones.
• Insist banks take "some percentage haircut" in bid price vs. lowest value the security was ever held on their books.
• Take equity in the banks participating in the auction, which "provides greater possibility of upside for the taxpayer," White says.