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The $700 billion and the PLAN

The congress and the house have approved the $700 billion rescue plan. However for those who had a chance to read through the fine print, there was disappointment in store….there’s wasn’t any plan. The proposal itself is actually a lose aggregation of definitions and statements of intent aimed at keeping the homeowners in their houses. The document passed by the senate simply lays down the guidelines for providing the Secretary of the Treasury powers to use $700 billion from the federal government to reduce the impact of the crisis on the US economy. What’s depressing, rather worrying, is that having known that this scenario was likely to play out for over an year now, this is what two of the sharpest and without doubt the most powerful individuals in US, with ready assistance of hundreds of the best brains in the world, come up with.

Below are the highlights of the “plan”:

A troubled asset?

The plan defines a troubled asset as any mortgage related asset originated or issued before March 14, 2008, the purchase of which the Secretary and the Chairman of the Board of Governors of the federal reserve deem necessary to promote financial market stability.

What role does the Secretary play?

The secretary has been authorized to establish a relief program that will purchase troubled assets from financial institutions at a price that is commensurate with the credit risk on that asset. He will also be responsible for publishing a methodology for setting the premium for classes of assets to be bought by the federal funds under this program.

What happens to asset bought by all that money?

The Secretary, as and when he deems fit, can request for, “loss mitigation measures on individual assets such as term extensions, rate reductions, principal write downs, increases in the proportion of loans within a trust or other structure allowed to be modified, or removal of other limitation on modifications.”

The assets may be held for a period till such time that the market conditions are optimal for selling the assets.

The golden parachute

Any financial institution seeking federal assistance shall:
“Limits on compensation that exclude incentives for executive officers of a financial institution to take unnecessary and excessive risks that threaten the value of the financial institution during the period that the Secretary holds an equity or debt position in the financial institution.”
Make a “provision for the recovery by the financial institution of any bonus or incentive compensation paid to a senior executive officer based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate.”
Prohibit “making any golden parachute payment to its senior executive officer during the period that the Secretary holds an equity or debt position in the financial institution.”
(Senior executive officer’’ means an individual who is one of the top 5 executives of a public company)

The guidelines will be issued in 2 months after the date of enactment of this Act and will be effective upon the issuance.

Guarantee from the institutions asking to be rescued by the govt.

In cases where the purchases of assets from any particular institution exceed $300,000,000, the Secretary can prohibit any new employment contract with a senior executive officer that provides “a golden parachute” in the event of an involuntary termination, bankruptcy filing, insolvency, or receivership.

Also any financial institution seeking help from the Fed will have to issue a warrant to the Secretary empowering him to receive preferred stock or debt instrument of value that the Secretary seeks appropriate. If sufficient shareholder approval is not received, additional share can be issued as a security. The institution will then not be allowed to dilute this security by diluting it by issue of shares, dividends or rights issues.

Does the Secretary get a free hand?

“Effective upon the date of enactment of this Act, such authority shall be limited to $250,000,000,000 outstanding at any one time. If at any time, the President submits to the Congress a written certification that the Secretary needs to exercise the authority under this paragraph, effective upon such submission, such authority shall be limited to $350,000,000,000 outstanding at any one time.” The president can further write to the Congress a request that the Secretary needs to exercise his authority all the way upto $700,000,000,000. So yes, there’s a free hand once the president okays it.

And finally…”No injunction or other form of equitable relief shall be issued against the Secretary for actions ……. other than to remedy a violation of the Constitution”

Needless to say, its sketchy at best. As I said earlier, there isn’t a plan. Infact there aren’t even general guidelines on how the money is going to be used. Is it going to be used to buy mortgages from institutions? Is it going to be given to the banks as capital or as a bridge loan? Does the money go directly to the US taxpayer as a grant? What happens if $700 billion does not work?

Any proposal to get the economy out of the logjam has to answer two critical questions – what is the amount of capital needed and most importantly, how is the capital going to be allocated? The plan answers the first one, and at that, partly. The second, to everybody’s dismay, remains completely unanswered.

The least the plan could’ve done was to set an arbitrary level of loss (depreciation in value of a house on which a mortgage has been taken) after which the Fed may take over an asset or provide a security cover, whichever way you please. That would’ve atleast set a realistic expectation for the financial institutions on how much their assets are worth in the worst case scenario and whether they need assistance or not. That would’ve also sent signals to the global investors indicating that yes, there are going to be losses, but “quantifiable” losses. Having seen big institutions go down, the crisis now is not only of capital adequacy, it is also one of credibility – how much everybody’s actually worth.

One may add a few concessions to tax payers here and a few hundred million for social security there, but what the congress has essentially done by passing this plan is to kiss the Secretary of the Treasury on the forehead, arm him with 700 billion dollars and having put all their remaining hopes on him, sent him on a war to save to global economy.

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