Dollars for Assets

Story Highlights:

• Some folks believe the $700 billion requested by the Fed and Treasury would be a sunk cost.
• But once complete, the plan is likely to use less than the total allocated, and the purchased assets could yield a return if they are held to maturity or re-sold to the investment community.
• Setting aside the merits of the plan and depending on many yet undetermined variables, the government could lose money, come out even, or possibly make something back on the deal.

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Congress continued debating the Treasury and Fed's financial system bailout plan Wednesday. Amid a number of complaints, the overall "price tag" is raising hackles on both sides of the aisle. After all, asking to spend $700 billion is no small request, and potentially more costly than the New Deal.

But it seems there's a general misconception the number would be a sunk cost. In other words, if the bill is approved, many expect to see a $700 billion line item on the next federal budget. But reality is more complicated. For starters, $700 billion is the cap. The feds may or may not need to use it all. They've requested a large lump sum upfront to ensure they have the power to act as swiftly as conditions require.

Further, a massive government purchase of structured debt products is probably more aptly viewed as an investment of sorts. The feds would be exchanging dollars for assets. Structured debt products still have value when divided into their smallest constituent parts—though each may have some "bad" loans, they will also have many more "good" loans. A few bad loans may go kaput, but the good loans will pay interest and principle as they mature. Therefore, one way the feds can recover their investment is by holding the assets until maturity.

However, the plan's primary aim is to reinvigorate the currently lifeless structured debt market. In the beginning, the government would seek to assign value to the securities by establishing some kind of reverse auction. The auction would require private firms interested in unloading these assets to submit competing bids—the lowest bid wins the sale. Theoretically the reverse auction will protect taxpayers from paying too much, but could eviscerate the banks.

After the auctions remove much of the current financial uncertainty, credit will start flowing more normally (so the theory goes). As the crisis in confidence abates and housing improves, the private sector will again want to own some of the previously shunned securities. As this rejuvenated free market expands, the government would sell their mortgage-backed assets back to the investment community.

In either scenario, the feds don't lose all their startup capital—no matter how daunting the number. Depending on many yet undetermined variables, the government could lose money (but not all of it), come out even, or possibly make something back on the deal. In any case, though the plan in aggregate requires further analysis, the so-called "price tag" in and of itself isn't as worrisome as many believe.