The Bailout: What Does Paulson Do Now?

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Can Treasury Profit?

"Valuation is going to be extremely hard," says Rod Dubitsky, managing director for asset-backed securities research at Credit Suisse (CS). "It they set the price too low, there won't be any sellers, but if they set them too high, the government will take too big a hit."

Dubitsky points out that the task will be somewhat simpler when Treasury buys assets from firms that have already marked down the value of their assets to current fire-sale prices. Those companies may well be more willing to sell—and willing to accept a price lower than competitors might—because they've already taken the hit to capital that banks continuing to carry mortgage assets at book value haven't. At the same time, Treasury's own low funding costs, combined with the fact that it can accept a lower profit than a private buyer likely would, mean that Treasury would be able to pay more for such assets than would a private buyer and still potentially turn a profit. The bottom line: Many initial purchases are likely to come from institutions that have already taken big writedowns on the value of their mortgage-related securities.

In other cases, however, Treasury may have little choice but to overpay, in the interest of preserving liquidity and reducing systemic risk. If, for example, a bank can't take the big hit to its balance sheet that would come from selling to Treasury at more realistic current prices but the risks to letting it fail are too large, Dubitsky argues that Treasury will likely pay up to prevent a failure from happening. And whole loans held on the originating banks' books are rarely marked to market. So in both those instances, Treasury may essentially overpay for the assets, but it will likely demand a larger chunk of equity warrants from the institution in return.

Of course, to get any of this under way, Treasury will have to staff up quickly. It has plenty of decisions to make there as well. The Department is still working on the pay scales it will offer, for example, and the conflict-of-interest rules it will put in place to protect the public interest. That will be critical in winning support for the program, since the government has little choice but to hire mortgage-securities experts from many of the same firms that need help getting the junky assets off of their balance sheets. They are the only people who really understand trading in the complex markets for mortgage-backed securities and the derivatives created from them.

Hiring Conflicts

Treasury officials did not respond to calls concerning implementation on Friday afternoon, and in a press briefing held the previous weekend to outline the initial plan (the core of which remains in the final law) they refused to discuss how they planned to proceed.

"The irony is, Paulson will not be able to find asset managers to run this that don't already have distressed assets on their own books; there's no one else to do it," says one source who is closely following the talks. This person warns that Paulson has to be careful in how he brings those people in, ensuring there are strong enough firewalls and other safeguards to avoid a further public backlash: "If Main Street was already concerned about writing a big check to Wall Street, imagine how they are going to feel when they hear the government is now hiring the guys who created the problem in the first place, and, by the way, their firms will benefit?"

Sasseen is Washington bureau chief for BusinessWeek.
With Theo Francis in Washington