If You Follow Only One Issue In This Bailout . . .

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Amid all the noise about limits on executive comp and other distractor issues, one central important issue stands out, in my view, as the most worthy of attention as Congress and the Fed wrestle over the terms of the proposed bailout: How much will Treasury pay for the mortgage-related assets/securities it proposes to unload from troubled banks? Put more pointedly, how much of a discount will the Fed impose on the supposed value of these asset to try to find a baseline from which the market can rebound? To (1) put the pain on the too-clever folks who caused this financial mess in the first place, (2) avoid the Fed taking on assets that will continue to fall in value and produce losses for all of us taxpayers, and (3) put the Feds in a position of maximum maneuverability to modify the mortgage assets they buy, we would like to see sales at a significant discount from "nominal" or "book" or whatever other misleading "value" the banks had previously put on these things. Of course, we don't want to exacerbate the crisis by forcing banks to destroy the asset side of their balance sheets and further seize up credit markets, either, but I don't get the sense that this is a significant danger (yet).

We haven't heard much on this big question, but early indications are mixed. Bernanke and Paulson today reiterated that some sort of reverse auction might be the best way to go; that is, have the banks compete to offer the lowest sales price, and the low bidder gets the toxic assets off its books, to be replaced by crisp, relatively-clear-value U.S. greenbacks. My sense is that this structure would serve the concerns mentioned above and produce an acceptable result for most reasonable-minded observers. On the other hand, another report out today suggest that Treasury is less sanguine about an auction, fearing that banks might compete too aggressively with each other to drive down prices to deeply depressed "fire sale" levels. This latter report interprets Paulson's comments as suggesting that Treasury intends to pay something closer to undiscounted long-term value ("hold-to-maturity") as opposed to current distressed value for the bad mortgage-related assets. This would, of course, raise the risk level for a big loss by Treasury and pose a serious threat to the value of the U.S. dollar.

We should all watch quite closely as Treasury reveals (one would hope soon) which of these valuation/auction methods it intends to pursue if the bailout proposal makes its way through Congress. In my view, the evaluation of the entire bailout rests on the resolution of this issue.