This story is excerpted from "Another Frightening Show About the Economy," a one-hour special report for This American Life. In the show, Alex Blumberg and NPR's Adam Davidson — the two reporters behind the popular "Giant Pool Of Money" explanation of the mortgage meltdown — explain what happened in the last week, including what regulators could've done to prevent this financial crisis from happening in the first place.
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After a dramatic two weeks on Capitol Hill and in the financial markets, President Bush on Friday signed into law a $700 billion bailout bill for Wall Street. Lawmakers acted to pass the legislation amid dire warnings that the U.S. economy was on the verge of collapse. But was the bailout plan a good idea? That's a question many Americans are asking.
After reporting on this crisis for several weeks, NPR's international economics correspondent Adam Davidson says that this is indeed a severe and scary crisis.
"And the more I report it, the more scared I have been," Davidson tells This American Life host Ira Glass as part of a one-hour special report on the last week of financial turmoil.
What is clear, Davidson says, is that spending $700 billion will help. "But it's also very clear that the plan we've been hearing all about, the Paulson plan, has a lot of problems. There are a lot of things that a lot of people do not like about it."
What's Not To Like About The Bill?
Though the law passed Friday was much modified from the original bill presented by Treasury Secretary Henry Paulson, the crux of his proposal remained: The government would be authorized to use $700 billion to buy mortgage-backed securities from financial firms. The idea is that, with these toxic assets off the books, lenders would start lending again, and the credit markets would unfreeze.
The main objection to this plan, says Davidson, is that "there's all these crappy assets the banks don't want, and the U.S. government is about to buy them. And so we're about to be the owners of $700 billion of crap."
"Also, these assets have absolutely no price," he says. "That is the cause of this crisis."
An asset's price is determined by what an investor is willing to pay for it. Since no one wants to buy mortgage-related securities right now, then at the moment, they have no price. That means the government is going to have to make up a price, Davidson explains.
If the price is too low, then the bailout won't work, because it will not provide banks with enough money to save them. But if the price is too high, then taxpayers will get ripped off. "So you have to find this magical price," Davidson says, but no one knows what that price is.
Meanwhile, banks don't have enough money, so they aren't lending any — and that's freezing up the economy, Davidson says.
An Alternate Plan
While Congress has been debating the Paulson plan, there is another financial rescue option that many economists prefer. Most economists whom Davidson and colleague Alex Blumberg have spoken with say a stock-injection plan is clearly better.
Instead of just taking toxic assets off of banks' books, the U.S. government would directly inject capital into ailing firms. In return, the government — and taxpayers — would get an ownership share in the firms equal to the amount of their investment. "The taxpayers, the government become stockholders and owners of the banks," Davidson says.
How is that better? First of all, it's simply easier, because it avoids trying to find the right price for mortgage-backed securities whose value is impossible to pin down at the moment, Davidson explains. If you give $10 billion to a bank, you get a $10 billion share.
"A lot of the economists I talk to say it's just fairer," he says. "It's a better deal for the taxpayer."
With the Paulson plan, the taxpayer ends up owning toxic assets of questionable value. If the mortgages bundled into these securities default, then the taxpayer is on the hook.
"In the stock-injection plan, we would not only own stock, we would own something called 'preferred stock,'" Davidson says. That means the taxpayer would be the last one to lose money, because the non-preferred shareholders would take the first losses. Taxpayers would be more protected and less likely to lose money, he says.
Why Not A Stock-Injection Plan?
If a stock-injection plan is better for the taxpayers, why wouldn't the government choose it over the Paulson plan? It turns out that many groups oppose the idea, Davidson says.
One group is conservative Republicans. "They just don't fundamentally, in their guts, don't like the idea of the U.S. government owning shares of private companies," he says. "It just smells like socialism to them and they can't support it."
Perhaps more importantly, banks really hate the idea. When the government took over insurance giant AIG, it essentially bought a huge share of the bank's shares and zeroed them out. All the shareholders lost billions of dollars and the chief executive of AIG was fired to boot.
So it was surprising to learn on Friday that, despite intense opposition from the powerful banking lobby, language authorizing the government to use a stock-injection plan did make it into the final version of the bailout bill. The law does not make a stock-injection plan mandatory, but it does leave it as one option that the Treasury secretary can use when bailing out a distressed bank.
But Was The Bailout Necessary?
Davidson says a majority of the economists he has spoken with agree that the current economic crisis is severe — and it's going to get worse.
"The original plan was not great," Davidson says. "This plan is a lot better. This plan is probably the best we can get, and something has to happen sooner than later."