Text size:

  • Small
  • Normal
  • Large
Henry Paulson, left, and the Federal Reserve chairman Ben Bernanke are silently heckled at the Senate banking committee meeting.
Henry Paulson, left, and the Federal Reserve chairman Ben Bernanke are silently heckled at the Senate banking committee meeting.

Mishandling could sow seeds of future turmoil

The panicked reaction of the markets to the proposed US bailout underlines the uncertainty over the rescue.

The panicked reaction of the markets that the proposed US bailout is meeting some congressional flak underlines just how uncertain everyone is about the long-term implications of the government rescue, which has the immediate aim of bringing stability and confidence back to the markets. If mishandled, the current bailout may yet lay the seeds of future financial turmoil. The US Treasury went into the weekend proposing that Congress give it a blank cheque and total legal immunity to buy up real estate assets that, following the summer takeover of Fannie Mae and Freddie Mac, will leave the government solidly in control of most of the American mortgage market. Congressional Democrats have fired back with draft legislation that would give the government equity stakes in most of the remaining financial institutions it does not yet own. While everyone agrees with the aims of the bailout, the stumbling block is in the details. In the Senate, the banking committee chairman Christopher Dodd has circulated a draft that includes the following elements.

Unlike the Treasury secretary Henry Paulson's plan, the US Treasury would receive wide authority and an initial US$700 billion (Dh2.57 trillion) to purchase a broad range of assets from a broad range of institutions. This includes not just residential and commercial mortgages, as initially envisioned by the Treasury, but any manner of bad debts - mortgages, credit cards, car loans among others - from US and non-US institutions alike.

This has been warmly greeted by foreign banks with so-called toxic assets in the US markets. Broadening the eligible assets served the political purpose of avoiding industry lobbying that could delay passage, and also created maximum flexibility should there be a future need to clean up toxic debt outside housing. A key point in the congressional counter-draft was that the Treasury would be subject to intense oversight by frequent reports to Congress, an independent inspector general and a review board including the Fed, Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission (SEC) and independent financial representatives nominated by members of both political parties. Some members of Congress were not too amused that Mr Paulson, a former investment banker, would have almost total say in how the bailout funds were to be used.

The most controversial element of the Dodd draft was that the Treasury would receive contingent equity shares - or senior debt for non-public entities - in financial entities being bailed out "equal in value to the purchase price of the assets to be purchased". Such shares could not be diluted by future stock splits. The idea here would be to give taxpayers some upside from cleaning up Wall Street's mess. This proposal potentially complicates the mechanism for purchasing assets as, frankly, few market operators know what the true values are of the purchased assets.

In a move to prove to the public that someone has to be penalised for future financial mismanagement at the senior executive level, there will be limits on executive compensation in any entities seeking to dump bad debt on the American taxpayer. Even the business-friendly US administration agrees that executive compensation will almost certainly be in a final bill, but it is seeking to soften the broader language in Dodd's current draft that financial industry lobbyists say grants government a free hand when regulating future executive pay.

The administration seems to agree with limits on severance packages for chief executives who created the current mess and are seeking a government rescue, but it does not want limits put on qualified chief executives who need to have incentives to lead the industry forward. For such measures to work, similar limits need to be imposed in other competing financial centres such as London, Frankfurt or even Dubai to send a firm global signal that mismanagement and undue risk taking will not be rewarded.

The Dodd draft would see property assets bought by the Treasury managed by the FDIC. That agency would join the Fed and the now government-controlled Freddies as a major manager of mortgages and related securitised assets. All three would develop proposals to prevent further foreclosures by modifying loans and reducing interest rates. Twenty per cent of government profits made from bad asset purchases would be funnelled into a Housing Trust Fund and a Capital Magnet Fund, with the balance going to the Treasury's general account.

Limits would be put on the money market insurance programme rolled out in haste last week. That programme would be limited to $100,000, in order to give this backstop the same limit as FDIC guarantees on bank accounts. The Treasury did not intend for this programme to handicap bank deposits in favour of money market funds. The programme would be in effect for only 120 days, or a full year at the written request of the Treasury.

The most contentious issue, not yet resolved, concerns the mark-to-market debate. Wrangling is under way to shape the mechanism that the Treasury will use to purchase distressed assets. Financial industry representatives are lobbying hard for an SEC holiday from mark-to-market accounting rules, and to ensure that prices at which the Treasury buys bad debt - protesting taxpayers would argue for low valuations - will not serve as the accounting base for banks to mark other holdings. This issue is critical for how the purchase programme will operate. It is also a detail that will have to be settled once asset managers are selected to help Treasury run the programme.

Banks are seeking accounting relief so that the toxic debt it unloads will not further constrain their balance sheets. Within the Treasury, there is a debate over whether such relief would be prudent in the short term, by helping prevent further immediate write-downs across the sector and helping banks rebuild capital and get credit markets flowing again. There are those opposed to this relief, arguing that accounting gimmicks may work in the short term, but it will create longer-term problems if it allows banks to either continue to hide bad assets on their balance sheets or prevents the financial system from using the bailout mechanism to come to terms with losses and purge the system of toxic debt.

Mechanisms to purchase assets are still on the drawing board, but officials indicate they will move extremely quickly to begin initial purchases, once a bill is signed. Mr Paulson, whose term runs only until January, does not intend to leave the buying spree to his successor, and this is where Congress is determined to be seen putting its mark and authority. In this battle of smoke and mirrors, it is the poor taxpayer who is left to pick the tab and wonder whether to trust anyone again.

Back to the top

More articles

Editor's Picks

 Would you like it in blue? An Afghan shopkeeper shows a burqa to a customer at a bazaar in Herat. (Aref Karimi / AFP /  April 13, 2014)

In pictures: Best business images for the week to April 24, 2014

Here are some of the best business images for the week to April 24, 2014.

 That's asking a lot: this four-bedroom duplex penthouse apartment  at Marina Residence in Dubai is for sale with an asking price of Dh15.7 million. (Courtesy Better Homes / April 2014)

In pictures: Palm Jumeirah penthouse listed for Dh15.7 million

A four-bedroom duplex penthouse in Marina Residence 3 on Dubai's Palm Jumeirah is on the market for Dh15.7 million.

 Room with a view from one of the 21 duplex penthouses located in the Gate Towers sky-bridge. The sports courts and swimming pools can be seen below. Courtesy Alda

In pictures: Aldar’s Gate Towers Penthouse Collection on Reem Island

Aldar launched its Gate Towers Penthouse Collection at Cityscape Abu Dhabi. The launch features 21 penthouses spanning the skybridge, with each having a private indoor pool and incredible views.

 Marina Square apartments Reem Island: Q1 2% rise. Studio - Dh65-68,000. 1BR - Dh75-95,000. 2BR - Dh110-145,000. 3BR - Dh170-190,000. Q1 2013-Q1 2014 no change. Sammy Dallal / The National

In pictures: Where Abu Dhabi rents have risen and fallen, Q1 2014

Find out how rental prices in the prime locations in Abu Dhabi have altered during the first three months of the year and the current rates you will pay according to data provided by Asteco.

 The Wind, Energy, Technology and Environment Exhibition takes place from April 14 to April 16. Above, the Dewa showroom during last year’s Wetex. Jaime Puebla / The National

April corporate and economic calendar for the UAE and overseas

From Cityscape to Wetex to stock-market holidays to nations reporting first-quarter GDP figures, here is our helpful calendar of April's business events in the UAE and internationally.

 Get the latest information on credit cards, bank accounts and loan products in the UAE. Mark Lennihan / AP Photo

Rates report: Latest on UAE loans, accounts and credit cards

Souqamal.com brings you the latest interest rates on banking products in the UAE.


To add your event to The National listings, click here

Get the most from The National