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Bills on the taxpayers?
By Xin Lian (chinadaily.com.cn)
Updated: 2008-11-21 15:24

"Taxpayers are paying for the Walt Street mistakes." For days, this criticism had been troubling Treasury Secretary Henry Paulson, and he still remembered vividly all the arguments triggered by his bailout proposal.

At a press conference on Sep. 17, Paulson reached out to his fellow citizens for their support. "The ultimate taxpayer protection will be the stability this troubled asset relief program provides to our financial system, even if it will involve a significant investment of taxpayer dollars. I am convinced that this bold approach will cost American families far less than the alternative -- a continuing series of financial institution failures and frozen credit markets unable to fund economic expansion."

Eloquent as he might have sounded, he was indeed entirely uncertain about the public response. Using 5% of the US GDP to rescue Wall Street money men is not something easy to sell, particularly to taxpayers.

No surprisingly, soon after the financial rescue plan was released, angry mails, calls and faxes flooded into the Capitol Hill. 122 economics professors from the ivory tower sent a joint letter to the Congress, challenging the equality of the plan, arguing it is essentially subsidizing the bankers with taxpayers' money. A USA Today/Gallop Poll showed that only 22% of Americans supported the relief scheme, compared to the 56% opposed.

The general election was less than two weeks away. Congressmen of both parties could not afford to understate the interest of the taxpayers. The political stakes were too high.

Then a coup shocked the GOP. Conservatives, led by Missouri Sen. Roy Blunt, complained against Bush Administration plan. Kentucky Sen. Jim Bunning strongly condemned the plan at the House Banking Committee hearing. He labeled the scheme "financial socialism", a deal that was "un-American". He said the plan would take extra $2,300 out of the purse of each American taxpayer, equivalent to "taking Wall Street's pain and spreading it to the taxpayers".

By and large, how the average American's interests could be protected became the focus of all negotiations. Who should pay for the rescue? How should the sum be spent? And how coud the plan avoid losses at the end of the day? These key questions remained open.

In the meantime, some House Republicans raised an alternative, a federal insurance program funded by part of the $700 billion pool. The logic was that, insured by the government, financial institutions and investors would not dispose of their holdings of subprime assets, so as to alleviate the burden on the taxpayers. The financial institutions would actually partly bankroll their own rescue when paying the premium, though their contribution would be disproportionately small.

Democrats also voiced their concerns. There should be strings attached, they argued, when the taxpayers come to the rescue. The public should have a share in the future benefits, if any, from the rescued financial institutions, and be protected against any potential loss thereof.

As Democratic congressman Rahm Emanuel put it, "Call this plan an investment, but you just can't make a fool of our taxpayers." Two underlying market rules were mentioned over and over again: returns should be in proportion to risk, and people who made bad decisions would have to bear the consequences.

Eventually, Banking Committee Chairman Christopher Dodd, a Connecticut Democrat, offered his version of a remedy: while buying distressed assets from listed financial institutions, the Treasury takes a share of equity equal to the purchase price of the assets being bought, in the form of non-voting common stock, preferred stock warrant and senior bonds, to guarantee taxpayers' share in the company's future dividends. For private beneficiaries, the government would take senior debt instead, securing seniority of repayment in full in case of liquidation.

But the new stock warrant claimed by the Treasury may dilute the interest of existing shareholders, and the rescued entities would have to categorize the warrant as a liability before the Treasury sells all its holdings. Both would discourage financial institutions from putting out their distressed assets for reverse auction. Even if they sign up for the government remedy, should they run a loss or go under, the taxpayers' entire investment would be at stake, never mind the questions of profits. Dodd's proposal was nothing more than a placebo.

Some congressmen noticed the problem. In response, they offered a "repayment provision". According to this arrangement, in five years, the White House Office of Management and Budget, together with the Congressional Budget Office, would assess the bottomline of the bailout scheme. If it lost money, the President would submit a bill to the Congress to levy a fee on beneficiaries out of their compensation. But the specifics of the repayment mechanism were yet to be clarified. Making the Wall Street vultures spit out the rescue dollars they receive could prove mission impossible. Given that dire situation of the only two survivors of the former "big five" investment banks, no one could foretell how the other financial firms would weather the crisis.

In practice, at a point when details of the bailout plan such as asset portfolios and pricing were far from clear, it was impossible to determine the overall cost of the bailout. The Treasury would issue $700 billion of TB to fund the relief plan, an amount which was supposed to be equal to the value of the debt that was to be acquired from the banks. So it would be counted as current fiscal deficit. If after five years, the plan was in the red, the loss would be covered by the beneficiaries or integrated into the fiscal deficit. But the rescue plan also allowed deposit insurers to borrow from the Fed without any ceiling. This could be risky. In case of a systemic failure in the banking sector, deposit insurers would have to handle the insurance claims, and the net loss could be colossal. Even if the loss could be amortized into the budget, the annual deficit could be staggering.

More importantly, the rescue cost depended on the speed of American politicians to reach a consensus in relation to the downward spiraling of the market. The deeper the market plunged, the higher the cost would be. A decision-making mechanism designed to safeguard the taxpayers might turnout to be counterproductive. The taxpayers' interests will ultimately be determined by the financial position of the plan, which in turn depends on trade-offs inside the government and the future trajectory of the market. The whole picture won't be clear until the Treasury wraps up the last toxic asset. But by then the new occupants of the White House will only claim the glory and blame the Bush administration for all the woes. The painful memories from the Wall Street may have already faded and history may witness new bubbles