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Broad Authority, Lots of Money And Uncertainty

By Binyamin Appelbaum, David Cho and Neil Irwin
Washington Post Staff Writers
Monday, September 29, 2008

Congress is on the verge of granting Treasury Secretary Henry M. Paulson Jr. sweeping powers to stabilize the nation's financial system. He would stand largely unfettered by traditional rules, largely unrestricted in his ability to spend $700 billion of federal money.

The Treasury Department would decide what kind of assets to buy, and which financial firms could sell them. It would decide how much to pay. And it would hire firms to manage its acquisitions, without having to obey the normal rules for hiring contractors. These decisions would take several weeks, Paulson said.

The results will determine whether $700 billion is enough to end the financial crisis.

"This is really an unusual situation, a highly unusual situation. And we need flexibility, we need a variety of tools, we need to figure out how to get out there in weeks," Paulson said in an interview last night.

It is not clear how patiently investors and depositors in troubled institutions will wait. Nor is it clear whether, in the meantime, the banking system itself will begin to recover from the uncertainty that is freezing the flow of loans to major corporations, small businesses and individuals.

Two European banks moved toward failure over the weekend: Bradford & Bingley, a British mortgage lender, and Fortis, a giant banking and insurance company based in Belgium. Several American institutions continue to teeter.

The legislation, which the House is expected to vote on today, is the latest in a series of government efforts to stem the wave of financial failures, which started with large numbers of Americans losing their homes to foreclosure. The bill allows the Treasury Department to buy mortgage-related securities devalued by those foreclosures in hopes of leaving troubled financial institutions with fewer problems and more cash.

With the political process nearly complete, the work of helping the financial markets has only just begun. The most critical decision facing the Treasury is how to go about buying troubled assets. Officials say the department may well use different approaches for different kinds of assets, rather than pursuing a uniform strategy.

The goal is not to vacuum all the industry's troubled assets into a federal holding tank. Rather, the government wants to determine credible prices for the assets held by banks, through the mechanism of buying some of those assets. If the plan succeeds, the prices paid by the government will become a new market standard, bridging the current gap between the higher prices sought by banks and the lower prices offered by investors.

"We need confidence, and this is about confidence," Paulson said.

In a practical sense, the government is trying to revive the markets because buying up all the troubled assets would require far more than $700 billion.

Twenty of the nation's largest financial institutions owned a combined total of $2.3 trillion in mortgages as of June 30. They owned another $1.2 trillion of mortgage-backed securities. And they reported selling another $1.2 trillion in mortgage-related investments on which they retained hundreds of billions of dollars in potential liability, according to filings the firms made with regulatory agencies. The numbers do not include investments derived from mortgages in more complicated ways, such as collateralized debt obligations.

Experts say the Treasury plan could do more harm than good.

If the Treasury pushes to buy troubled assets at bargain-basement prices, many banks that hold similar assets would be forced to mark down their holdings. Such losses could push some institutions over the edge.

If the Treasury overpays, taxpayers could lose massive sums.

"There are more questions of doing this and the consequence of doing it poorly than anything else," said Richard H. Baker, a former Congressman and the chief executive of the Managed Funds Association, which lobbies for hedge funds.

Baker recalled during the savings and loan crisis of the late 1980s and early 1990s, the government set up the Resolution Trust Corp. to buy real estate and other assets of banks that went into bankruptcy. The RTC eventually sold some of these properties at such severe discounts in Baker's home state of Louisiana that real estate values around the region became depressed.

The Treasury faces few boundaries on how it can proceed, and many of those can be waived at the department's discretion.

The program is focused on mortgages and related securities -- unless the Treasury deems it important to buy other kinds of assets, such as car or student loans. The Treasury plans to focus on mortgage-backed securities in the first round of purchases.

It is focused on buying from banks, insurance companies and other financial firms with substantial U.S. operations -- unless the Treasury decides it's important to buy from any foreign institution that holds mortgage assets.

The Treasury plans to hire private companies to manage what it buys, and the bill gives the department the power to waive the rules that govern the use of contractors.

"The Secretary of the Treasury still has huge latitude," said Douglas Elmendorf, a senior fellow at the Brookings Institution. "Now we have to wait to see how he chooses to proceed."

Treasury officials said the broad discretion is important to the success of the program and the health of the financial system. Including foreign firms, for example, is intended to encourage those institutions to continue lending to domestic banks, which often offer mortgage securities as collateral.

The bill also requires the Treasury to establish an insurance program in which private firms would pay premiums to the government for a guarantee of their assets. But the department can shape how this program would be implemented. The difference between the premiums that the firms pay and the value of the assets would count against the $700 billion cap on the total federal effort.

And Treasury has the authority to decide what restrictions should be imposed on companies that seek government help, including limits on executive compensation, and what kind of stake the government should take in companies, so that taxpayers benefit if the companies return to profitability.

In practice, that is likely to mean companies will pay different costs for participation. Representatives of financial companies say the details of the plan will determine whether and how much they participate.

Treasury officials said that flexibility was important to ensure that companies are willing to participate. There is concern that some companies might refrain, either as a demonstration of financial strength or to avoid restrictions.

When the Federal Reserve made loans available to investment banks earlier this year, for example, some companies stayed away, fearful that borrowing would be interpreted by investors as a sign of weakness.

Scott Talbott, a lobbyist for the Financial Services Roundtable, said he thought the program would attract wide participation, but that some of the strongest financial institutions might well refrain.

"If you're in a position of strength, you don't need the program," he said. "And if you're in a position of weakness, you'll do it regardless of the restrictions."

In structuring the program, the Treasury will rely on outside experts. The government already has tapped Edward Forst, Harvard University's executive vice president, to work on the legislation and oversee the launch of the program. But Forst is planning to return within two months to Harvard, where he started as an executive vice president on Sept. 1.

Paulson said he will find longer-term help. "We'll have an organization in place and hire a really strong person to run this," he said. "We're going to get someone who understands markets and we'll find someone who's a real professional to come to Treasury and run it."

The bill also forces a re-evaluation of "mark to market" accounting rules, under which banks and other financial institutions must adjust the value of their assets to reflect current market prices, even if they intend to hold the assets for the long term. Bank executives have blamed these rules in part for their troubles, saying that distressed sellers have pushed market prices below actual values, forcing unreasonable write-downs.

The Securities and Exchange Commission already has the power to overrule the board that sets those accounting rules, the Financial Accounting Standards Board, but the bill restates that the SEC had authority to change mark-to-market rules. It also orders a study be conducted on the role mark-to-market rules played in the current crisis.

Lynn E. Turner, a former chief accountant at the SEC, criticized the provision, which he said was designed to help bend the commission to the banks' will.

"What they've done here is say let's study whether banks should be allowed to lie," he said. "Regardless of whether you had mark-to-market accounting, you would have this problem, which is banks running out of cash. And they're running out of cash because they made loans to people who aren't paying them back."

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