Bail Now, Ask Later

"Not-So-Gentle" Ben Bernanke and Hank “Bazooka” Paulson had a clear message for antsy legislators on Tuesday: spend now, question later.

Speaking before the Senate Banking Committee, the regulators urged rapid ratification of their proposed $700.0 billion bailout package. Fast action is needed, Federal Reserve Chairman Bernanke said, to "avert what otherwise could be very serious consequences for our financial markets and for our economy."

The U.S. -- and global -- financial system has been rocked over the past year by instabilities arising from the U.S. subprime crisis. Imprudent lending to American homeowners for overpriced real estate has led to a global credit crisis as loan defaults have brought into question the value of mortgage-backed securities that provided the ultimate financing. That has led to a withdrawal of lenders from many of the world's credit markets, freezing up the banking system and calling into question the value of debt securities and insurance on them. (See "Too Clever By Half" and "Derivatives And Dangerous Times.")

Aside from using public-sector money -- and lots of it -- to solve imprudent private-sector activity, Congress may want to add provisions that benefit average taxpayers, notably homeowners who are suffering as the values of their properties decline. There is also a question of how much to punish the companies and executives that need the government aid.

Treasury Secretary Paulson said having the proposed plan work is the "greatest protection for taxpayers" and "they are already on the hook." He warned that if the U.S. financial system is not stabilized, then taxpayers will pay the costs. Bernanke said the Treasury’s plan to buy illiquid assets from financial institutions in a reverse auction will create liquidity and help shed light on how much these assets are worth while boosting investor confidence in financial institutions.

Setting the prices for this massive investment by the federal government is the biggest connundrum. The Fed chief wants Wall Street to help guide its buyer in finding that sweet spot halfway between what companies could get for their troubled holdings if they sold them today and what they would be worth if they held them to maturity.

Should prices be set too high, the government will be giving participating institutions unloading the assets a break at the expense of taxpayers, who would end up owning overvalued assets.

If, on the other hand, Uncle Sam low-balls sellers, then other banks would suddenly see their assets fall because of the perverse impact of mark-to-market accounting. These reporting rules are increasingly coming under criticism. (See "Steve Forbes On Ending The Crisis")

“The problem is if the government pays pennies on the dollar, mark-to-market rules would make every other bank take this paper loss on its books,” said John Berlau, director for the Center for Entrepreneurship. “So there will be a tension between getting the best deal for the taxpayer and not spreading further systemic risk from massive write-down the government purchase could force.”