Jon Kyl, September 22, 2008

Almost everyone agrees the financial market crisis was precipitated by the bursting of the "bubble" of overinvestment and speculation in home buying. Once prices started falling it became apparent that the amounts of many mortgages exceeded the real value of the homes. Buyers concluded they either could not, or should not, continue making mortgage payments, and foreclosures have resulted.

Unfortunately, the original mortgages have been sold several times over to financial institutions that now don’t know how many of their mortgages will be paid off and how many will default. Even though most will be paid, the uncertainty prevents them from being priced and, therefore, sold. Meanwhile, the institution has had to "write down" the value on their books. Because these assets cannot be liquidated, the institutions aren’t lending money because they want to preserve their capital. The result is a financial market that will, eventually, grind to a halt.

The effect will be to jeopardize lending to consumers and business, spreading the "illiquidity crisis" throughout the economy and hurting all Americans.

Some big firms have been bailed out and largely taken over by the government. These were targeted stopgap measures designed to prevent the turmoil of individual firms from broadly infecting the economy. But, as Treasury Secretary Henry Paulson recently announced, the federal government must now take a "comprehensive approach to relieving the stresses on our financial institutions and markets," and address the root cause behind the instability.

Think of the loans now being held on the balance sheets of banks and other financial institutions as assets like your home. You may think it is worth about $100,000. But do you think you could sell it today for that amount? Probably not -- at least not at a price sufficient to pay off your mortgage. So, as of right now, its sale or market value maybe half of what you think is its real, or intrinsic value.

Under Treasury’s plan, the federal government will purchase illiquid assets -- these are mortgage-backed securities that currently no one wants to buy because of their low market value. The price will be somewhere between the presumed intrinsic value (i.e., your $100,000 house) and today’s market value (assume $50,000 -- so let’s assume it’s purchased at $75,000). Because of the transfer of $75,000 from the federal government, the financial institution will now have money to begin responsibly lending to individuals and business, thus freeing up the market.

The Treasury Department will hold the assets until their value increases (in this case, to at least $75,000) and then sell to get the taxpayers money back. To gain access to the billions of dollars Treasury will need to begin buying these illiquid securities, Congress will have to pass legislation; and part of the challenge is to ensure that the taxpayers get their money back (i.e. the $75,000 in our example). That’s not going to be easy.

The consensus among congressional leaders is that we have an economic emergency on our hands, and we have to come together as a nation to respond as quickly as we can -- hopefully by the end of the September. But there is no strong consensus yet on exactly how to do this, while at the same time protecting taxpayers.

If we act responsibly, there is no reason we can’t get the job done. The goal must be to free up the market so Americans can go about their business as usual. Unlike the "bailout" of certain big financial institutions, this Treasury plan doesn’t help any particular company. Rather it ensures that all of us can rely on our banks for loans, our money market savings for retirement, and our employers for our jobs.

The two key things that we have to get right are: (1) taxpayer protections and (2) preventing the bill from becoming a vehicle to carry either party’s political agenda.

The key taxpayer protection is to structure the plan so that the assets will eventually be sold for at least, if not as much, as the Treasury paid for them.

As to advancing political agendas, there are already some who are proposing tacking on a second "stimulus" package to this bill, i.e. massive new spending and taxpayer "rebates." Such additional spending will do nothing to stabilize our financial markets, but will add billions in new debt that future American taxpayers will eventually have to repay.

Senator Jon Kyl, a Republican, represents Arizona in the U.S. Senate. He serves on the Senate Judiciary Committee, the Finance Committee, and the Energy and Natural Resources Committee.