18 Tough Questions (and Answers) About the Bailout

Really good questions and some half-baked answers about the bailout

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Saul Loeb / AFP / Getty

U.S. Treasury Secretary Henry Paulson speaks to the media regarding the failed Congressional bill to bailout Wall Street at the White House in Washington, D.C., September 29, 2008.

On Sept. 25, I got an e-mail from a reader asking a lot of moderately aggravated, very smart questions about the bailout plan proposed by Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke. There were 18 of them--more, really, considering that most contained multiple queries. I hadn't finished answering when the House of Representatives killed the plan Sept. 29. But it soon got a second life, so I went back to answering the e-mail. The result provided a handy guide to how the bailout plan is supposed to work and who's going to pay.

1. Where will the $700 billion--plus go? What exactly will it buy and from whom? That's the, uh, $700 billion question. Mortgage-backed securities are to be the main target, and banks the main sellers. But Paulson and Bernanke wanted a fund that could buy pretty much anything from anyone.

2. How exactly is this bailout supposed to save credit markets? Paulson and Bernanke described it as a way to jump-start trading in mortgage securities for which there's no market at the moment, thus allowing banks to clean up their balance sheets and get back to lending. But a lot of economists outside government believe that the real problem is that lots and lots of financial institutions are insolvent. If that's true, it would make more sense for taxpayers to give them cash outright and take a big ownership stake in return. The bailout plan allows Treasury to do that. But it also allows Treasury not to.

3. Why can banks get bailed out but not me when my portfolio tanks? It's a variant on the old saw "If you owe the bank $100, that's your problem. If you owe the bank $100 million, that's the bank's problem." Leveraged financial institutions (banks, investment banks, hedge funds) make investments with lots of borrowed money, so when their portfolios tank, they can quickly find that they can no longer make good on their debts. When that happens to a single institution, it's no big deal to let it fail. But if it's happening to several of them at once, that leads to a downward spiral of failure begetting more failure and retrenchment begetting more retrenchment. Any bailout risks rewarding the profligate and the foolish. But we're getting to the point at which financial-sector problems are starting to hurt people who didn't profit from the boom.

4. If more currently outstanding mortgages default, won't the problem just keep going on and on? Yes; that's a big part of the concern at Treasury and the Fed, that economic trouble emanating from the financial system will cause even more people to fall behind on their mortgage payments--which would lead to even more trouble in the financial system.

5. Are we all just supposed to trust that mortgage lenders and Wall Street types have learned their lesson and will not continue to exacerbate the problem? It's fair to assume that mortgage lenders and Wall Street won't make the same mistakes for another generation, at least. But they will do their best to figure out new ones. And while bubbles and crashes will always be with us, a regulatory structure that is more restrictive of financial innovation may help.

6. If these so-called securities are mortgage-backed and the mortgages are in default, would the money be better spent just buying up the mortgages themselves instead of the securities? And renegotiating mortgage rates? A number of economists think buying the mortgages makes more sense. I think the reason Treasury doesn't want to do that is that it would be a far more time-consuming and labor-intensive process than simply buying securities on the open market. As for renegotiating mortgages, a brand-new program is using up to $300 billion in Federal Housing Administration guarantees to encourage mortgage servicers to move people out of adjustable-rate loans and into fixed-rate ones with lower face values. And if Treasury owned a few hundred billion dollars' worth of mortgage securities, it could put pressure on servicers to renegotiate loans rather than foreclose them.

7. Is there any chance that any of the bailout money will be recouped? Yes. Mortgage-backed securities are still, you know, backed by mortgages. They're worth something--and in some cases more than what the Fed would pay for them.

8. Who determines how much to pay for these securities? They haven't really figured that out yet. One possibility would be to hire private managers who would get a share of any profits. And there's talk about using various auction methods to price them.

9. Who is at fault here? Home buyers for buying too much mortgage or lying on their applications? The mortgage lenders for approving such loans without due diligence? Or the creators of the mortgage-based derivatives? Until a few years ago, getting approved for a mortgage was a pretty good indication that you could afford to make the payments. Buyers were relying on a time-honored financial rule of thumb that mortgage lenders and their Wall Street backers decided to throw out the window. I'd blame the lenders, the securitizers, the regulators and Congress first, with buyers probably last. Although I'd still blame 'em a little.

10. Without the bailout, is it really likely that we will see the end of the world as we know it? Given the existence of the Federal Deposit Insurance Corp. and the activist stance of the Federal Reserve, it's hard to envision a 1930s-style breakdown in which banks shut their doors and depositors lose all their money. The fear is of a situation in which lending to both businesses and individuals stops almost completely, which would lead to a pretty sharp downturn.

11. What is the difference between Wall Street and a casino? (Not meant as a joke.) On Wall Street, the dealers get paid a lot more and are often allowed to bet alongside the customers. Oh, and much of the money raised on Wall Street actually goes to productive purposes. Except when markets are in bubble mode.

*Actual reader e-mail

More Answers For Justin Fox's full replies to all 18 questions, go to time.com/18questions