Best Explanation of Bail Out Bill

I like Kimberley Amadeo’s clear explanations of the economy. Here she talks about the Bank Bail Out Bill.

The guts of the bill is the same as the three page document submitted on September 21 by Treasury Secretary Henry Paulson. Paulson had asked Congress to approve a $700 billion bailout to buy mortgage-backed securities that are in danger of defaulting. By doing so, Paulson wants to take these debts off the books of banks, hedge funds and pension funds that hold them.

Why did this become a crisis instead of a serious problem?

The bailout was triggered by a record $140 billion being pulled out of money-market accounts, usually considered the safest of investments. That’s because investors were moving the funds to U.S. Treasuries, causing yields to drop to zero. To stem the panic, the Treasury agreed to insure these funds for a year. In addition the SEC banned short-selling of financial stocks until October 2 to reduce volatility in the stock market. (Source: WSJ, Shock Forces Paulson’s Hand, September 20, 2008)

And what does the bill contain?

-Bailout installments of $250 billion each.
-An oversight committee that will review Treasury’s purchase and sale of mortgages. The committee is comprised of Federal Reserve Chair Ben Bernanke, and the leaders of the SEC, the Federal Home Finance Agency and HUD.
-The ability for Treasury to negotiate a government equity stake in companies that receive bailout assistance,if it is the government’s best interest.
-Limits on executive compensation of rescued firms. Specifically, companies will not be able to deduct the expense of executive compensation above $500,000.
-Government-sponsored insurance of mortgage-backed securities,and other assets, purchased before March 14, 2008.
-A requirement that the president propose legislation to recoup losses from the financial industry if any still exist after five years. (Source: CNNMoney, Rescue Bill Released, September 28, 2008.)

Were there other things in the bail out bill?

The bill contains an additional $149 billion in tax breaks and allows regulators to suspend the mark-to-market rule. This law forced banks to continually write down the value of their mortgages to present-day levels. This meant that bad loans, which could not be resold in the current panic-sticken climate, had to be valued at less than their probably true worth. (Source: Bloomberg, Bank-Rescue Plan Wins Approval as House Reverses Vote, October 3, 2008)

Was there any fear about the future solvency of banks?

Most in Congress recognize the need to act swiftly to avoid further meltdown. It has become a case of fear feeding on fear, with banks afraid to disclose their bad debt, which will lead to a downgrade in their debt rating, which will lead to a decline in their stock price, which will lead to their inability to raise capital, which will lead to bankruptcy. This fear of disclosure has led to an overall panic, fed by rumor, which has locked up the credit markets.

There is more in Kimberley’s explanation. Take some time to read it.