U.S. Treasury Proposes Massive $700-Billion Mortgage Markets Rescue Plan to Congress

The program is ambitious in scope, and the Treasury is requesting significant resources from Congress to get the job done. The Treasury is requesting, and needs, a big stick to deal with the escalating financial crisis—money and interbank markets froze up last week and we saw a massive flight to quality on a scale that has not been seen for decades.

The program is comprehensive. While primarily aimed at roughly $2.5 trillion in subprime and Alt-A mortgage debt that was originated in the 2005 to early 2007 period, it also includes roughly $2.5 trillion in commercial real estate debt. There has already been about $500 billion in global write-offs through June 2008; with an additional $100–150 billion in estimated write-offs through mid-September, the book value of these assets has already been significantly lowered.

The Treasury did not provide much detail on how the assets will be priced, other than through market mechanisms where possible, or through the use of "reverse auctions" where the price of a package of securities is progressively lowered until the auction is fully subscribed. We expect discounts on asset transactions will be anywhere from 20% to 80%, depending on the quality of the assets or the asset package involved.

While the $700 billion in funding appears to be enormous, and will surely precipitate cries of outrage across the country, it is important to keep in mind that the ultimate cost taxpayer cost is likely to be much less than $700 billion.

That cost will be determined by how the economy and the housing market perform over the next several years. It would be a reasonable bet that the economy and the housing market will recover by 2010, and the prices of the securities purchased by the Treasury over the next several months might actually rise by then. In that case, the cost to the taxpayers would be minimal, and there might even be a chance that the Treasury could make a profit on this endeavor.

On the other hand, if the economy continues to slide into a deeper recession, dragging the housing market down along with it, the costs to the taxpayers easily could escalate to several hundred billion dollars.

As Global Insight indicated last week, the Paulson plan is not a magic wand. Even with the assumption that the Treasury starts to execute the plan starting in the fourth quarter of 2008, with Treasury auctions ramped up by perhaps $50 billion or so every two weeks or so commencing in October, a final round of write-offs to be borne by the financial system will exact further short-term deflationary pressure on the economy. Obviously the federal deficit will take a one-time hit of $700 billion in fiscal 2009.

This new strategic initiative from the Treasury certainly has the potential of accomplishing the broad goals of allowing the financial sector to clean up its books, attract new sources of capital, and move on from the crisis.

But the economy currently is battling recessionary forces, and is screaming for lower borrowing costs and the restoration of more normal credit conditions. The sooner that the Fed and the Treasury execute this bold plan, and take the necessary supporting steps in the form of lower benchmark interest rates, the sooner the acute pain from this 13-month-long crisis will be over.