The Bailout: What Does Paulson Do Now?

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Signal to Markets

In a report issued the morning of Friday, Oct. 3, Glaser said Treasury officials are close to deciding which asset classes to purchase first. They are also combing through data on financial institutions so that whatever initial purchases they make will signal to the markets that Treasury helped the "right" institutions—in other words, that the taxpayers' money is going toward those institutions whose financial stability will give the biggest boost to market confidence and whose prospects can most realistically be improved by Treasury purchases.

Scott Talbott, a senior vice-president for the Financial Services Roundtable, an industry group, puts it more bluntly: "They will target the firms that have liquidity trouble, but no so much trouble that they are essentially nonoperational. If a company is beyond repair, the Treasury plan is not going to save them."

That means Treasury is likely to start out buying from banks, in an effort to shake the credit markets back into shape. "I think he's going to go after the biggest [banks] first," said Stephen Auth, chief investment officer of equities for Federated Investors, a mutual fund and investment manager that manages more than $300 billion. "He wants to get them back in the business of lending."

Establishing Prices

Auth also figures that Treasury will concentrate on mortgage-backed securities that are widely held, rather than unusual or one-of-a-kind issues. That should have a multiplier effect in helping bolster other banks, even if they don't take part in the auctions. By purchasing assets similar to those that other institutions hold, Treasury would essentially establish a new market price, which the nonparticipating banks could use to improve their balance sheets. That might also reassure other investors enough that they start buying as well.

But big banks may not be the only initial target. To build congressional and popular support, Treasury officials are also said to be acutely aware of the need to demonstrate that the benefits of the program go beyond Wall Street, to Main Street. Glaser believes that means Treasury will also quickly ramp up direct purchases of assets, including whole loans, from troubled regional thrifts and banks. Many of these institutions, which are economically critical in smaller local communities as well as politically influential in many congressional districts, are struggling under the weight of poorly performing home equity loans and construction loans made to builders who've now gone belly up. To keep both constituencies happy, Treasury will likely buy up lots of those assets from strategically targeted markets around the country.

"I don't know who the 117 banks are on the FDIC's 'at-risk bank' list, but I'd bet the bulk of them are regional institutions, and the bulk of their problems are in loans to developers," says Glaser. "That's a huge drag on these communities, and if the Treasury can free up their capital, the political benefits would be huge."

Whoever Treasury buys from initially, the biggest issue is going to be how it prices the assets. After all, part of the problem is that the market for these securities has dried up, making it hard to figure out what any of them are worth amid fears that the underlying mortgages have gone sour faster than expected. Here, Treasury has to walk a fine line. The point of the plan is to recapitalize the banks and other institutions by taking bad loans off their books in exchange for cash. If Treasury pays fire-sale prices, that will do little to relieve the pressure on the banks' balance sheets. But the more it pays, the greater the risks to taxpayers.