The Rescue Plan: What It Will and Won't Do

Experts say that new plan may encourage lending, but it won't stop a recession.

Oct. 15, 2008— -- When the Bush administration announced its new version of the $700 billion financial rescue plan first approved by Congress earlier this month, many observers cheered and optimism helped drive U.S. stocks to record gains.

Now, as the dust settles, economists and other experts are analyzing how the plan will help the U.S. economy -- and how it won't.

"The nature of the financial crisis has morphed from a housing problem to a credit crunch to a full blown modern day bank panic," said Kenneth Rogoff, an economics professor at Harvard University and a former economist at both the International Monetary Fund and the Federal Reserve.

Government officials, he said, "haven't solved the problem that the economy is going into a significant recession, but they've stopped the hemorrhaging."

Experts say that while the plan should help shore up banks, it won't help housing prices recover, it won't stop the U.S. from shedding jobs and it may result in higher taxes down the road. One critic questions whether the new plan is even legal.

Treasury Secretary Henry Paulson, meanwhile, has acknowledged that the plan won't stop the country from facing "some challenges for a number of months."

"There is no doubt that -- that a lack of confidence in the financial system, banks slowing down their lending have had an impact on the real economy," Paulson said in an interview today on Good Morning America. "And businesses haven't been borrowing, jobs have been in jeopardy, people's 401(k) plans have declined."

But, he added, "as we stabilize the system and as banks begin to lend and begin to lend to consumers, begin to lend to businesses, businesses resume hiring, we will make progress here."

Here's how the plan is supposed to work: The government will allocate $250 billion of the $700 billion package to purchase equity in U.S. banks. The list of banks include Bank of America, JPMorgan Chase, Citigroup, Wells Fargo, Goldman Sachs, Morgan Stanley, Bank of New York Mellon and State Street, which will receive a total of $125 billion. The government is expected to invest the remainder of the $250 billion in smaller banks.

Raising Capital and Confidence

In return for its investment in the banks, the government will receive preferred shares – stocks that don't come with voting rights but do get paid out ahead of common shareholders if a company goes bankrupt – from the banks.

According to the plan, banks will pay the government a 5 percent return on the investment – a dividend – annual for five years. At the end of the fifth year, the dividend requirement jumps to 9 percent. The government will also have the option to buy common stocks from the bank.

Participating banks will be subject to executive compensation limits set by the government.

Proponents of the plan say it will make banks more confident about lending to each other because each will know that the other has sufficient capital to cover its debts. And, they say, it will stabilize the banking system enough that banks will feel comfortable lending to consumers and businesses again.

The government hopes that the moves will aid banks in their search for private investment.

"Our goal is to see a wide array of healthy institutions sell preferred shares to the Treasury, and raise additional private capital, so that they can make more loans to businesses and consumers across the nation," Paulson said in a news conference Monday. "The needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it."

As the Treasury Department takes steps to encourage lending, the Federal Reserve is attempting to fill the needs of businesses that have had trouble securing loans: The Fed is buying commercial paper – the short-term debt many businesses use to finance day-to-day operations.

The Federal Deposit Insurance Corporation, meanwhile, is temporarily insuring the loans banks make to each other and has also expanded its guarantee of bank deposits to include all non-interest bearing accounts, including those worth more than $250,000 – a move that also targets businesses.

Rescue Plan Questions

Despite the government's assurances, myriad questions remain about the scope and consequences of the plan. While some experts say they're confident that the plan will ultimately ease the credit crunch, others, including Rogoff, aren't so sure.

"It doesn't necessarily get people lending again," he said. "It keeps the system from collapsing."

Alan S. Blinder, an economics professor at Princeton University and a former vice chairman of the Federal Reserve, said he would have liked to see the government's plan tied to pledges by the banks that they would resume lending.

"These institutions, like many other people, are traumatized by what's gone on," he said. "Since the capital injections didn't have any requirements about expanding lending, maybe the banks won't expand lending or won't expand it much, so the hopes that some people have had that this is really the way to get lending going again might be dashed."

Even if the plan succeeds, some argue that the government won't get the most bang for its buck.

Gerald O'Driscoll, a former vice president at the Federal Reserve Bank of Dallas and a senior fellow at the Cato Institute think tank, compared the government's 5 percent dividend requirement with that recently negotiated by billionaire investor Warren Buffett. Last month, Buffett's Berkshire Hathaway company agreed to provide Goldman Sachs with a $5 billion investment in return for a 10 percent dividend return.

The government, O'Driscoll said, should have sought a higher return.

"I think we should have gotten 9 percent to start with," he said.

There is disagreement about whether the government will stand to lose or gain money through its bank investments.

Sanford Weill, the former chairman and CEO of Citigroup, was optimistic that the government would recoup its money and then some.

"The U.S. government borrows money at a rate of one or two percent and we'll be getting a minimum of five percent, so the taxpayer should be making an interest profit right from the beginning," Weill told "Good Morning America" on Tuesday.

But Dean Baker, of the Center for Economic and Policy Research, said he expects at least some of the banks participating in the program won't survive – the money the government loses on those investments, he said, will soak up any potential returns.

"The intention is to lend money to hundreds of banks," he said. "Clearly some of them will go under."

There are also questions about how the new plan will affect the program originally proposed as part of the $700 billion rescue package: the heavily-criticized Troubled Asset Relief Program.

Under TARP, the government was to spend hundreds of billions to buy troubled assets – including mortgage-backed securities – from banks.

Neel Kashkari, the assistant Treasury secretary who is charged with overseeing the plan, said Monday that the department has created a policy team to work on a mortgage-backed securities purchase program.

But Baker said the government may choose not to move forward with TARP at all and instead spend more money on buying stakes in banks.

"Most economists really say it's an inefficient use of the government's money. Our interests here are in insuring that the banks are adequately capitalized and that's just not the most effective way to do it," he said.

Some worry that overall, the government's rescue effort will far exceed its initial $700 billion price tag: Barry Ritholtz, the author of "Bailout Nation: How Easy Money Corrupted Wall Street and Shook the World Economy" and the CEO of the institutional research firm Fusion IQ, told this week that the plan could eventually cost the government $2 trillion to $3 trillion.

William Poole, the former president of the Federal Reserve Bank of St. Louis, said the amount the government is spending could eventually force higher taxes and cuts in federal spending.

"There was significant deficit going into this mess and now the federal government is adding hundreds upon hundreds of hundred of billions of dollars in outlays," he said. "That saddles the taxpayers with a permanent level of interest on that debt. ... The federal finances are going to be in a very fragile situation when all this is straightened out."

Poole, who initially supported the government's bank investment plan, said he's also wary of another consequence. It appears, he said, that the government has made it mandatory for the country's largest banks to participate in the plan.

Initially, the plan was supposed to be voluntary, he said.

"I do not believe there is any statutory authority to make it mandatory," Poole said. "Should one of the banks challenge it in court and say to the Treasury, 'You have no authority to impose this on us,' ... it could further exacerbate the financial crisis."

No Avoiding a Recession

Experts agree that, in the short run, the new plan won't head off a recession.

A better lending climate may allow businesses to shed fewer jobs, but it won't stop job losses overall, Blinder said. The United States lost 159,000 jobs last month.

"The job cuts cause less spending and less spending causes more job cuts," Blinder said. "That's the vicious circle that defines a recession ... that dynamic holds true whether or not you have a credit problem."

And while the plan may make it easier for homeowners to obtain mortgages, it won't bring housing prices up to their old levels, analysts say. The prices, they say, were too high in the first place.

"I think the heart of the housing problem is that on average in the United States, house prices are still above equilibrium and house prices are going to have to decline," Poole said. "That means there will be defaults and foreclosures."

O'Driscoll cautioned against reading too much into the stock market's record rally earlier this week.

"I think that consumers and investors both are going to be cautious for a while. The exuberance of the stock market [Monday] isn't going to translate into immediate spending," he said.

"Most likely we're in a recession," he said, "and it's going to take a while to get out."