What Happens if Congress Doesn't Pass the Bailout

"Today, the government failed to govern as it should have. Compromise was thrown out the window and tyranny of the minority is the rule of the day. No one, least of all me, was thrilled with the bill. It's often said that a camel is a horse designed by committee, and this bill is certainly a camel...but it is the best that a diverse group could come up with and it needs to be enacted in some form with dispatch." - Daniel Alpert, Westwood Capital

The vote count on the $700 bn bailout plan to fix the financial system should come as a shock.

Democrats voted three-to-two for the bailout, while Republicans in the House of Representatives voted two-to-one against a plan championed by a Republican President, a Republican Treasury Secretary, a Federal Reserve chairman appointed by a Republican, and Republican party leaders in both the Senate and the House.

And now it's on the Republicans, who must step up to the plate and back their compatriots in the Democratic party to rescue the financial system, as the Dems may not attempt a vote again unless Republicans get their backs.

Yes, the bailout would effectively form one of the world's largest assisted living facilities for the financial sector, a shelter for the heart of the world's economy.

Yes, it would create a state-sponsored sovereign wealth fund if the full $700 bn is used, 100% debt-financed, the world's largest leveraged blind pool, as economist Edward Yardeni notes.

Yes, US taxpayers now own Fannie Mae (FNM), Freddie Mac, and American International Group (AIG), and possibly soon all sorts of Kryptonite created in the most expensive, impenetrably stupid freelance experiment to finance the purchase by US taxpayers of homes, to move the needle on the homeownership rate four percentage points to 68%.

But despite the man-on-the-street backlash, a growing consensus is forming among economists and analysts that the bailout is very much needed--otherwise, the US will see a domino-like failure of financial institutions unlike this country has ever seen.

The Federal Reserve has been desperately trying to pump liquidity into the system for a year now, but banks instead are hoarding that capital and not lending as much as they have historically to small businesses and consumers.

That's because they have been hit with losses and taken writedowns because they've lent out a lot of capital now sitting in the form of empty houses, apartment complexes, office parks and strip malls across the country. As writedowns continue to soar, banks will continue to hoard, and that bank hoarding chokes the economy.

Banks not lending causes businesses to stop hiring, it causes jobs to be lost, which causes families to be hurt, as family bills including tuition bills go unpaid.

Right now about 4% of loans are delinquent, if you load in the defaults, the rate goes as high as 10%. And as more option adjustable rate mortgages reset next year--they reset after five years, so the 2004 loans and on are now resetting to higher rates, the loans made during the height of the bubble--the defaults will soar and more bank losses will occur. The economy will get worse if the banks are not recapitalized.

What happens if the rescue plan is not passed? And what's in the plan that you must be aware of?

The Rickety Escape Hatch if the Bill Fails

Systemic financial collapse is upon us. Five US and European banks, including Wachovia and Washington Mutual, have nearly fallen to pieces, Wall Street has cratered in the wake of the demise of Bear Stearns, Lehman Brothers and American International Group. Merrill Lynch just barely saved itself, and meanwhile the world's central bankers are opening up a fire hydrant gusher of global liquidity never before seen.

Can the US Federal Reserve come to the rescue if Congress can't get its act together?

Already, the Federal Reserve, with the blessing of Buzzsaw Ben, have enacted Plan A since August of 2007, involving dramatic cuts to interest rates to below zero on an inflation-adjusted basis.

The Fed could next cut rates to zero from 2% on an intra-meeting basis (ahead of its next meeting), using the cover of inflation being kept at bay for now as oil drops to $95 from $147. Commodity prices are dropping as well.

If Congress doesn't act, the Fed may be forced to embark on an expansion of Plan B.

The Fed's moves would entail massive liquidity injections beyond its already historic opening of the spigots. It would entail increasing its term auction facility for cash-starved banks beyond $300 bn, a sum that only just recently doubled.

It would also entail getting central bankers around the world to boost its reciprocal currency swap arrangements, whereby central banks lend to each other to inject funds into the money markets, beyond the $620 bn underway now, already up from $330 bn.

The Fed's Creaky Balance Sheet

The Fed itself may be forced to take on even more illiquid assets if Congress won't let Treasury do it, beyond the $29 bn the central bank has taken on in the Bear Stearns rescue merger with JPMorgan Chase and beyond the $10 bn of mortgage-backed securities minted by Fannie and Freddie that the Fed has already bought.

So the Fed may be forced to take onto its increasingly creaky balance sheet tough-to-value mortgage securities to provide some kind of floor to these toxic securities, created in the off-balance sheet economy, minted by Wall Street and Fannie Mae (FNM) and Freddie Mac (FRE), warehoused in banks' structured investment vehicles away from their financial statements, bought giddily by hedge funds, all of which intensified the illiquidity crisis.

This would be tough to pull off. The Fed has already dangerously expanded its balance sheet to over $1.2 tn to deal amidst a panic-driven demand for cash, as banks continue to hoard the Fed's record liquidity injections in their reserves.

Banks still balk at lending to each other, evident in the fact that the Fed funds rate is now triple the target rate the central bank has set, an indication the Fed has lost control of this key mechanism. Bank hoarding is evident too in the fact that the Fed's liquidity efforts have not entirely shown up in the lending markets.

The Fed's balance sheet is getting hurt. According to economist Edward Yardeni, during the week ended September 24, the assets of all Federal Reserve Banks increased $218.3 bn to a record $1.2 tn:

*These assets are up 36% year to year. Two weeks ago, they were up just 3.8% year to year;

*The difference between the Fed's total assets and its Treasury securities held outright is at a record $737.3 bn. This sum includes lots of doggy assets held outright (i.e. $29 bn from Bear Stearns);

*"Other loans" jumped $218.3 bn during the week. Borrowing by broker-dealers jumped by $45.9 bn;

*"Other assets" rose $82.4bn.These include currency swaps extended to foreign central banks.

What Happens if the Rescue Passes

The markets will stabilize. The government then buys the $700 bn max in damaged assets by selling Treasurys in similar batch amounts with yields of 2%. As Bloomberg notes, investors around the world are clamoring to buy risk-free Treasuries, so the market should be able to absorb the jump in supply without a significant increase in yields.

The government then makes a profit down the road on these assets, as the sales could yield at least triple what the government borrowed in the markets to finance them. Bloomberg calculates that a spread between borrowing at 3% to buy assets yielding 10% could reap income of $40 bn to $60 bn annually for US taxpayers.

The Loopholes in the Rescue Plan

Executive compensation: Companies that auction off more than $300 mn in damaged securities to the government are banned from signing any new compensation contract loaded with golden parachutes with a senior executive it wants to hire to help it through the crisis. The parachute in this case would be triggered if the executive was fired or the company went bankrupt.

Watch this loophole: The loophole here is that companies can still access the $700 bn program and still pay their executives fat cat compensation if these executives choose to just simply walk out the door, otherwise known as 'take the money and run.'

Also, the plan does not cover executives who were still at their companies before the bailout was enacted.

So executives who drove their companies into a ditch can still access the program and walk away with fat cat pay. And executives who may want to parachute in and help may not want to now because the legislation will nix their golden parachutes, which are usually tempting come-ons from distressed companies to lure them in the door.

(PS and forget about the plank that says companies can't deduct on corporate tax returns any pay above a half a million--companies will pay whatever they want, as the company and its shareholders foot the tax bill.)

Treasury's Purchase Price for Kryptonite: It's a plus that the US Treasury says it won't shell out more for these Kryptonite assets versus what Wall Street and banks--in their impenetrable stupidity in thinking that house prices can defy the laws of physics and rise eternally, inexorably higher--initially paid for them. Yes, it's chilling that banks have already taken $523 bn in writedowns and losses on them.

Watch this loophole: Banks who got these assets by merging or buying other banks out of bankruptcy can try to unload these assets at prices higher than what the Treasury sets for them. Check out the plan's language here--the Treasury exerts discretion over the prices it pays for this kryptonite: "The Secretary can make such purchases at the lowest price that the Secretary determines to be consistent with the purposes of this Act."

To be consistent with the purposes of this act. Meaning, to save the system at all costs, forget the taxpayer. And so what if the Treasury discloses the prices paid later on--years from now, are you going to be reading the fine print here? And do you think Congress by then will care?

A Bigger Role for the Federal Deposit Insurance Corp.

The FDIC has decades of experience behind it protecting the financial system and taxpayers. More bank mergers should be encouraged because they are less costly to taxpayers, as banks themselves, via their FDIC insurance premium payments, typically foot the bill for bank failures not taxpayers.

Ironically, the FDIC may be forced to bail out banks hurt by the government's own moves. A recent survey by the American Bankers Association found that 27% of the nation's 8,500 banks faced combined losses of $10 bn to $15 bn on Fannie and Fannie preferred shares. The value of Fannie and Freddie shares got wiped out in the rescue of these two mortgage giants.

The survey found that 85% of the affected institutions were community banks with less than $1 bn in assets. A dozen could go under and 40 may have to be sold to rivals due to the Fannie and Freddie, says the Independent Community Bankers of America.

What a United States of Bailouts Means to Foreign Purchasers of US Debt

Foreigners finance the US's $450 bn budget deficit, its whopping $9 tn federal deficit, and its $700 bn trade deficit. Foreign central banks own about half of the US's public debt and they finance nearly three-quarters of its new debt.

As the US government inflates its way out of this crisis, that means the US dollar will drop in value and it may lose its status as the premier foreign currency reserve.

Yes, the Paulson plan won't stop house prices from falling. Yes the plan feels like a theoretical, highly expensive, completely unfair pre-emptive fiscal strike to the citizen on the street. Elected officials now see that voter anger, hot enough to melt silver, may cost them their heads this coming election.

But the markets are begging for a floor, a threshold price, under these rotting assets to move this sickness of the balance sheets of damaged banks. That cure is needed now.

What the Bailout Costs Taxpayers

The $700 bn bailout bill is about 6% of GDP, a little more than a third of what other banking crises cost other countries (largely due to corruption, says the IMF) and nothing compared to the Great Depression.

That 6% will fast approach levels of public spending not seen since the second World War, when public outlays hit 10% of GDP, says JPMorgan Chase.

But the fact that the US government is moving with alacrity now should be seen as a positive, a plus.

Japan's banks started to go under in 1991, but it took the country until 1998 to fix its damaged banking system. The S&L crisis took six years to fix and cost 3.7% of GDP. The Reconstruction Finance Corp. of the Great Depression era, which injected massive amounts of funds into the system, lasted 21 years, though it morphed into an effort to support World War II.

The delay in enacting these rescue plans kept these economies underwater longer than necessary.

The $700 bn surpasses the FDIC's estimate of half a trillion of residential mortgages delinquent in the beginning of summer, out of a total of $10.6 tn in mortgage loans outstanding. But that sum could grow.

So it is time for taxpayers who took out loans they should not have, who are sitting in homes worth less than their mortgages, to do their part.

Forgo the temptation to put your mortgage on the federal government--meaning fellow taxpayers--and do all you can to work out your loans on your own.