What Are the Other Bailout Options? An Explainer

Treasury Secretary Henry M. Paulson Jr. has emphasized the urgency of his bailout plan by warning that inaction would be disastrous. But are there other options besides total inaction on the one hand, and Mr. Paulson’s $700 billion bailout on the other hand?

Let’s start with the fundamental problem that the bailout is trying to solve. To function, Wall Street firms cannot have too much debt relative to their underlying assets. If they do, other banks won’t do business with them – much as your local bank won’t give you a $100,000 loan unless you have some collateral behind it. In recent years, banks went deeper and deeper into debt, in an effort to turbo-charge their returns. Now they are discovering that their assets are not worth what they thought. The combination of high debt levels and falling asset values has paralyzed the financial markets. In econ-speak, the firms have too much debt relative to their assets.

The government could reduce that debt-to-assets ratio either by decreasing the numerator (debt) or increasing the denominator (assets). The first option would involve reducing the debt obligations of these institutions. The Treasury Department’s $700 billion plan to buy mortgage-backed securities and other contracts from the banks falls into this category. Proponents argue that this plan can be executed quickly and that the government will end up making back a significant chunk of the $700 billion, if not all of it, when it sells the assets down the road.

The second option would be to increase the firm’s assets. Several economists, as well as a number of Democratic lawmakers, are advocating the second approach (or at least some combination of the two strategies).

One way to do this would be to have the government invest in the firms. In other words, the government would give Wall Street institutions more capital, presumably also from taxpayer funds, in exchange for a cut of the firms’ profits down the road. Douglas W. Elmendorf, Paul Krugman and various others have advocated this. Luigi Zingales has put forth a proposal for the banks to raise capital without taxpayer money by having creditors forgive some of the banks’ debt in exchange for partial ownership of the same banks. These and other critics say it is not fair to make taxpayers spend hundreds of billions of dollars rescuing these companies without also giving them a stake in the upside.

Other ideas – including conditions on oversight authority and executive pay, which could theoretically be combined with either approach – have also been pitched.

For example, Robert Reich, the former labor secretary, recommended that the bailout be replaced with a regular ol’ bankruptcy, organized by the government.

A number of critics say the bailout plan pays too little attention to homeowners and to “Main Street.” Dean Baker recommended that the bailout should give priority to keeping people in their homes — i.e., reducing the amount of money people owe on their mortgages — instead of maximizing the returns the government can get from mortgage payments. Nouriel Roubini suggested creating a government body in charge of helping Americans find debt relief, modeled on the Home Owners’ Loan Corporation established during the Great Depression. Mark Thoma proposed the creation of a “worker bailout fund” for those afflicted by layoffs nationwide.

It’s not totally clear to me that helping people keep their homes will resolve the larger liquidity problems that are afflicting the financial system and, in the process, putting the economy at risk of falling into a deep recession. My colleague David Leonhardt will discuss this later in a separate post.

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