Will It Work?
Spencer Platt/Getty Images
By Robert E. Litan
So, will it work? Now that Congress has passed the bailout bill -- an unprecedented riverboat gamble aimed at preventing financial meltdown in the United States and possibly around the world -- that's the question on everyone's minds.
In the short run, we'll know if it works by looking at the "TED Spread" -- the difference between the most commonly used interest rate for inter-bank lending and the interest rate on short-term government debt. This spread is essentially a measure of credit risk: because short-term government debt is considered almost risk free, the difference between the rate for government debt and the rate for bank lending is a good indicator of how risky it is for banks to lend to one another. The higher the spread, the greater the fear of default on inter-bank loans. It was when the TED spread spiked near an unheard of four percent that Treasury proposed the massive bailout in the first place, a bailout that will hopefully soothe the rattled nerves of banks and so they can resume lending to each other in confidence. If the TED comes down, we'll know that this has happened.
But we may not know immediately, since the devil is in the details -- and not just in the legislative details. The Treasury Department must still issue guidelines on how it's going to buy up the troubled mortgage-related and other asset-backed securities covered by the bill. Those guidelines may very well determine how eager the intended participants -- banks, insurance companies, pension plans, and so on -- will be to sell to the Treasury. In addition, the bill's well-intentioned provisions limiting executive compensation and giving the government an equity stake in firms that sell the securities may also discourage some of those firms from showing up at the bailout party -- to what extent, we simply won't know. And it may even be some time after the election before we really have a good idea about participation, because the Treasury's purchasing guidelines might change when the new Administration takes office.
And the uncertainty doesn't end there. I doubt the public is aware that even the adoption of the Treasury plan may not avert the need for the Treasury and the Fed to do more institution-specific deals like the ones already done for AIG, Fannie and Freddie. This is because even if the plan can quiet the inter-bank lending market, the institutions selling the securities may only gain added liquidity -- that is, they'll have an easier time buying and selling assets -- but will not necessarily gain additional capital. There may be a large hue and cry if the government gives the financial institutions prices for the troubled securities that exceed the already marked-down values on the institutions' books. But unless that is the case, there is no way (at least that I can see) how this plan will add to the institutions' capital. Conversely, if the sale prices fall below the values currently shown on the books, then the banks and other sellers will actually lose capital, at least as measured under conventional accounting rules.
As a result, institutions in need of capital now are still likely to need capital after the plan is in place. If they can't raise it in private markets -- and in this environment, it may be a miracle if anyone can -- then the Treasury and the Fed will have to decide again, on a case by case basis, whether to inject public funds into ailing companies in exchange for stock. I'm not sure many in the public or on Capital Hill realize these hard decisions may be coming, especially if the economy continues to sink as rapidly as the latest jobs and other economic indicators suggest. But I'll bet this prospect is keeping beleaguered officials at the Treasury and the Fed up at night. I fear they (or their successors) won't sleep easy for a while.
Robert Litan is Vice President for Research and Policy at the Kauffman Foundation (Kansas City) and Senior Fellow in the Economic Studies and Global Economics Programs at the Brookings Institution (Washington, DC).
