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If Financial Bailout Package Is Needed, What's Best?

As Congress tries again to pass a financial rescue plan, the question remains whether a bailout is actually needed—and if so, what are the options.

Do Nothing

There’s no shortage of people proposing that Darwinian market forces can and should sort out the problem.

“Capitalism is where the market does its work,” legendary investor Jim Rogers, CEO of Rogers Holdings, told CNBC Wednesday. “You let things collapse…and you have a clean growth afterwards.”

Variations on that idea include letting financial institutions such as IndyMac and Lehman Brothers fail and allowing shotgun marriages, such as Citigroup and Wachovia.

The free market school also says government is also a source of the problem.

That includes the issue of moral hazard—using taxpayer funds to bailout reckless private companies and encouraging more risk in the future.

For Investors

“Government policy caused this problem,” says the Cato Institute's Dan Mitchell, citing, among other things, easy money from the Fed and the existence of government supported entities such as Fannie Mae and Freddie Mac.

Mitchell and other free market champions say if the only other choice is a bailout, “the correct response is to do nothing.”

“That’s not an option,” says economist Robert Brusca of Fact And Opinion Economics. “Once the Treasury Secretary and Fed Chairman say 'we need a blank check, and don't ask, just do it,' they've told us there's big trouble out there.”

WALL STREET IN CRISIS - A CNBC SPECIAL REPORT
WALL STREET IN CRISIS - A CNBC SPECIAL REPORT

That thinking is underscored by the stock market's historic selloff Monday following the House’s surprising defeat of the bailout bill’s first iteration and the near frozen credit markets of late.

Treasury Auction

Though Treasury Secretary Henry Paulson’s original plan is short on details—and has since been saddled with unhelpful provisions—its goal is simple.

The government—and possibly private sector firms—will buy mortgage-backed securities to shore up the balance sheets of financial firms. This is turn will reintroduce some pricing model, returning liquidity to a thin and depressed market.

“Conceptually it works,” says one former FDIC official. "It’s sort of a trust-me plan.”

In the savings and loan crisis, the FDIC, and later the Resolution Trust played that role, but in this case there’s a vacuum.

“You don't have any natural stabilizing mechanism," says former senior Treasury official Robert Glauber, who now teaches at Harvard University. “The fundamental argument here is to get these markets unlocked.”

AP

Critics say the process is impractical and thus won’t work.

“It doesn’t solve the big hole in the balance sheet unless they vastly overpay for these products,” Nobel Prize-winning economist Joseph Stiglitz told CNBC. "It’s an impossible task...buying up all these bad assets.”

Recapitalization Plan

Stiglitz and others support more aggressive and direct government intervention, as was the case in the Swedish banking crisis of the 1990s.

Under this model, the US government would supply capital in exchange for some sort of ownership stake, which is “more transparent” and a better deal for taxpayers, says Stigliz, now with Columbia University.

Others say though a recapitalization removes some uncertainty it has its own complications. For one, if the government gets a stake, it dilutes existing shareholders. What's more, capital infusions might also keep open some institutions that should fail or be merged into another.

Recapitalization “goes further down the road to nationalizing the banking system,” says Brusca, who adds, “You don't want to be in hock to Uncle Sam and have him have voting rights.”

Glauber, for one, isn’t ruling out the possibility of recapitalization, but at a later stage. “There may be solvency issues,” he says, if the private sector can’t produce enough capital. (He expects vulture funds and other firms to wind up participating in the Treasury auction.)

Eliminate Mark To Market

For some, part—if not all—of the solution lies in a simple but radical change in current accounting rules: the so-called mark-to-market rule, or FASB 157.

Protecting Your Portfolio - An Investment Guide
Protecting Your Portfolio - An Investment Guide

The rule, which went into effect in late 2007, basically says the existing value of a security is based on what you can sell it for in the current market place.

The rule is “well-intentioned,” says Joshua Ronan, professor of accounting at NYU’s Stern School of Business, but has created the market equivalent of a "negative feedback loop" or transactional gridlock.

“If the market is temporarily depressed for a number of reasons, then you are compelled to value these assets at what you can sell them for. But any number of these assets—CDOs—are very illiquid, thus trading is thin,” explains Ronan.“As a result, you have to resort to models, and in this environment people will be very cautious and mark them down."

Brusca says institutions seeking a waiver of FASB 157 could be required to accept many of the same conditions—such as restrictions on CEO pay—now in the current legislation.

The current bailout legislation includes language restating the authority of the Securities and Exchange Commission to suspend FASB 157 if it is in the interest of investors and taxpayers.

Some say not so fast.

“I don’t think the solution is to abandon the rule,” says Glauber, who played a key role in the first Bush administration’s savings and loan bailout efforts. “It needs to be enforced orderly. Sophisticated investors simply don’t trust the numbers being put out.”

There’s also considerable speculation that the mark-to-market rule will complicate price discovery in the Treasury auction process.

Right now the Treasury plan—as obscured as it may now be—remains the best hope, but hardly the only one.

“This plan isn’t a do-or-die plan," says Brusca. "This is just the plan du jour. If they don't pass this plan, they'll be another."

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