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245 IRET Congressional Advisory 1 (2008)

handle is hein.taxfoundation/iretcgadv0242 and id is 1 raw text is: INSTITUTE FOR RESEARCH ON THE ECONOMICS OF TAXATION IRET is a non-profit 501 (c)(3) economic policy research and educational organization devoted to informing the public about policies that will promote growth and efficient operation of the market economy. September 27, 2008 Advisory No. 245 RUSH TO BAILOUT Treasury Secretary Paulson has put forward a plan for a dramatic intervention by the government to shore up the financial system. It is predicated on the fear that credit markets could freeze up and damage the entire economy. Many banks and other institutions are unable to sell distressed assets immediately for the cash they need to meet current obligations. Mark-to-market rules require the banks to value the distressed assets at current fire-sale prices, which may be well below their intrinsic value. The low valuations are bringing the banks up against their minimum capital requirements imposed by bank regulators. This raises the threat that the banks will be closed, making it hard to tap their normal sources of credit. The panic becomes a self-fulfilling prophecy. Secretary Paulson's solution is to have the government purchase the impaired, and consequently illiquid, mortgage backed securities that are at the heart of the trouble. This would remove them from the books of distressed financial institutions. He is hopeful that the assets retain a good deal of their face value (some Administration estimates run as high as 93 percent). If so, and depending on how much the government paid for the assets, the government might be able to recover the outlays at a modest cost or perhaps even make a profit for the taxpayers. The program would help the banks preserve their capital, although the extent of that would depend on how much the government paid for the assets. The higher the price the government were to pay, the less of a hit the banks would take to their capital cushion from selling the mortgage related securities at a loss. This would get them back on their feet, while buying time to sort the assets out. However, it would increase the risk to the taxpayers. The best solution requires some time. It would involve an orderly unbundling of the mortgage backed securities to separate the good from the bad loans. This would make it possible to value the securities, and enable them to trade again. Those banks that suffered serious losses would have to raise new capital to restore their solvency. Those that could not would have to go into FDIC receivership, and be sold off to other institutions or liquidated. This approach would not involve risk to the taxpayers. The key question is one of time. If there is an imminent threat of a credit market meltdown, then we may be forced to accept the proposed intervention. If there is a way to buy more time to sort things out, then less drastic remedies are available. Is this haste really necessary? The economy and the markets are not falling apart. The financial sector, the housing sector, and the auto sector are having trouble. The technology sector, agriculture, energy, health care, and other services are doing pretty well. g~*m A3. S I 66. 6 All ~so

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