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White House Crisis Plan: Buy 'Bailout Bonds'?

During World War I, Americans were exhorted to buy Liberty Bonds to help their soldiers on the front.

Treasury Secretary Timothy Geithner
Treasury Secretary Timothy Geithner

Now, it seems, they will be asked to come to the aid of their banks — with the added inducement of possibly making some money for themselves.

As part of its sweeping plan to purge banks of troublesome assets, the Obama administration is encouraging several large investment companies to create the financial-crisis equivalent of war bonds: bailout funds.

The idea is that these investments, akin to mutual funds that buy stocks and bonds, would give ordinary Americans a chance to profit from the bailouts that are being financed by their tax dollars. But there is another, deeply political motivation as well: to quiet accusations that all of these giant bailouts will benefit only Wall Street plutocrats.

The potential risks — politically for the administration, and financially for would-be investors — are considerable.

The funds, the thinking goes, would buy troubled mortgage securities from banks, enabling the lenders to make the loans that are needed to rekindle the economy. Many of the loans that back these securities were made during the subprime era. If all goes well, the funds will eventually sell the investments at a profit.

But, as with any investment, there are risks. If, as some analysts suspect, the banks’ assets are worth even less than believed, the funds’ investors could suffer significant losses. Nonetheless, the administration and executives in the financial industry are pushing to establish the investment funds, in part to counter swelling hostility against the financial industry.

Many Americans are outraged that companies like the American International Group paid out many millions in bonuses despite crippling losses and multibillion-dollar rescues from Washington.

The embrace of smaller investors underscores the concern in Washington and on Wall Street that Americans’ anger could imperil further efforts to stimulate the economy with vast amounts of government spending. Many Americans say they believe the bailout programs — and the potentially rich profits they could yield — will benefit only a golden few, including some of the institutions that helped push the economy to the brink.

“This is an opportunity to forge an alliance between Main Street, Wall Street and K Street,” said Steven A. Baffico, an executive at BlackRock, referring to the Washington address of many lobbying firms. BlackRock , a giant money management firm, is playing a central role in the government’s efforts and is considering creating a bailout fund. “It’s giving the guy on Main Street an equal seat at the table next to the big guys,” he said.

The new funds are still under discussion, and they are unlikely to be established for several months, if indeed the plans go through at all.

But the comparison one industry official uses to illustrate the mistake that America must avoid is the large-scale privatization in Russia in the 1990s, which involved a transfer of entire industries to a few, well-connected oligarchs. That experience tarnished the idea of free-market capitalism in Russia and undermined its program to move toward a market economy.

“It is really, really important to allow Main Street in,” said the official, who was involved in discussions about the plan but who asked for anonymity because he was not authorized to speak about it publicly. “They are getting taxed for this problem. They should have an opportunity to participate in the recovery.”

Still, it is unlikely that everyday investors would play a major role in financing the bailouts through these funds. Hedge funds and other private investment firms are expected to invest far more money. The Treasury has not said how much money it intends to raise from individuals; first it wants to select about five fund managers to participate in the program to buy beaten-down securities. These firms must demonstrate an ability to raise about $2.5 billion among them. It may select several more fund managers later.

Perhaps more important than the money would be the political bonus of having thousands or even millions of taxpayers — whose portfolios have nose-dived during the crisis and whose tax dollars are financing bank bailouts and stimulus packages — profit from the toxic asset plan.

To head off the political risk of using public subsidies to move the assets from banks into the hands of private investors, the Treasury has already announced that, as part of its plan, it will retain part ownership of the toxic securities and loans, thus ensuring that taxpayers will share some of the gain if the assets’ prices rise.

But the plan to allow small investors to participate directly with their own money goes further.

Critics like Joseph E. Stiglitz, a Nobel Prize-winning economist, argue that the bailouts merely privatize profits and socialize losses.

But if the plan goes well, including everyday Americans as buyers of the assets may encourage them to support the government’s program and avoid another American International Group-style firestorm. If investors lose money, however, the effort could backfire.

“If this turns out to be great but you have kept it away from Mom and Pop and the rich are favored, that looks bad, but it’s also bad if you have people who are burned,” said Jay D. Grushkin, a partner at the law firm of Milbank, Tweed, Hadley & McCloy.

Some of the biggest investment managers in the United States, including BlackRock and Pimco, have been consulting with the government on ways to rebuild the country’s broken financial markets.

On the day the plan was announced by Treasury Secretary Timothy F. Geithner, both Bill Gross, the co-chief investment officer of Pimco, described it as a “win-win-win policy,” and Laurence D. Fink, BlackRock’s chairman and chief executive, said his firm would take part.

Jonathan D. Colman

The fund industry has been in discussion with the government but insists the Treasury has not been prescriptive about the type of funds it wants established. In its letters to potential investors, however, the Treasury requires fund managers to set out how they will include retail investors, saying applicants “must note whether, and if so how, it plans to structure the fund to facilitate the participation of retail investors in the fund.”

Individuals could participate in the funds by investing just a few hundred dollars, although the details are still being worked out.

If selected — likely to happen by mid-May — money managers like BlackRock could begin a fund within weeks.

As well as BlackRock and Pimco , Legg Mason , another big mutual fund company, and BNY Mellon Asset Management, a big asset manager, have said they are interested in starting retail investment funds to participate in the government’s plan.

For the investment managers, the benefits are potentially large. These big firms can charge healthy fees to investors for taking part. They will also have the marketing prestige of being the firms the government turns to at a time of crisis to help sort out the country’s financial mess.

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