Newswise — In Washington, D.C., Congress has begun debating the $700 billion bailout to buy toxic assets from banks and other investment companies in an effort to keep the U.S. economy afloat. Peter Summers, an assistant professor of economics at Texas Tech University, said that though the bailout could be well intended, it could create a vortex that would suck the market down with it.
Though the Paulson Plan hopes to use the U.S. Treasury to purchase bad assets to keep companies afloat, Summers said that there is no guarantee that a company could avoid going bankrupt, even after it divests its toxic assets to the American taxpayers. It could cause the price of the questionable assets to continue spiraling downward. "There are a couple of questions that the plan the treasury put forward doesn't answer," he said. "One of the big unanswered questions is how do you figure out what the price for these bad assets should be. The Paulson plan doesn't answer how prices are determined."
Suppose a firm has sick mortgage-related securities valued at $1 each, Summers said. If the market is currently valuing such assets at 50 cents and the Treasury plan offers something close to this price, that firm would have to mark considerable losses. Such a firm may become insolvent even with the bailout plan, and a low price could still mean considerable uncertainty and further bankruptcies.
On the other hand, he said, the Treasury could offer to buy these assets at a price closer to a dollar. This would amount to using taxpayers' money to recapitalize these firms: That is, to reverse most or all of the losses they'd otherwise suffer on these assets. So a high price could provide enough capital to get financial markets working more or less normally again.
Still, this raises another unanswered question, he said, which is what will taxpayers get in return for having taken bad assets off these companies' hands. If the treasury pays a price close to the original value, this would be a huge benefit to a company's stock and bond holders.
"Requiring participating firms to grant the Treasury an equity stake in return would ensure that at least some of the benefit is returned to the taxpayers," he said. "Otherwise, it truly is a bailout of existing managers and stock holders at the taxpayers' expense."
Summers can discuss what has caused the recent economic woes. From the slumping housing market, to sub-prime mortgages with killer adjustable rates, the end of the investment banking era as Morgan Stanley and Goldman Sachs agreed to new regulations on their businesses from the Federal Reserve, the impending recession and how the U.S. economy influences the global market, he can shed light on how some of these complex economic issues at hand fit into the past, present and future macroeconomic picture.
"This current recession or economic slowdown certainly has the potential to be as bad as everyone thinks," Summers said. "I've heard that this is the worst financial crisis since the Great Depression more than once. But the decline in employment hasn't been as bad as in previous recessions. That's the main difference with this current slowdown or recession. One of the differences in this recession as opposed to the one in mid '70s is that that the real side of economy, meaning goods and services, was doing relatively well up until recently. Output had been growing, albeit slowly, and we weren't seeing job losses and unemployment rates as severe as in past recessions."
In August, the unemployment rate jumped from 5.7 to 6.1 percent, though employment has been falling since September 2007.
"The really scary developments have been in financial markets as opposed to goods and services markets," he said. "It looks like that has started to change."
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