With oil spiking and the dollar and global markets falling as the world waits for news on the final terms of US Treasury Secretary Henry Paulson's (pictured) $700 billion bail out plan, one analyst has given up his day job to ask the questions to which we all need answers.

The latest turmoil has been sparked by dissent in Congress and by Democratic demands that mortgage borrowers be allowed to change the terms of their borrowings and keep their homes, as well as concerns that the cost of the rescue package could damage the dollar.

Mark Cliffe, global head of financial markets research at ING, said given that the US government bail out appears to be evolving almost by the hour, definitive forecasts are futile.

He said today that his day job will have to be suspended until he knows the answers to four questions:

  • How will the distressed assets that the government is buying be valued?
  • How far is the US government willing to go to bail out its distressed financial institutions?
  • How much support will be given to struggling mortgage borrowers? and
  • Will there be changes to accounting regulations?

He said the US government’s commitment to buy the troubled assets from the banks appears to be becoming increasingly open ended although details of how the proposed reverse auctions will actually operate remain scarce.

The key issue is the level of valuations that will be placed on the assets. If they are too low, the banks will resist the scheme because they will be faced with bigger losses and more pressure on their capital bases.

That then raises the question of how far they will be compelled to participate. If the prices paid by the Treasury are too high then the taxpayer will be on the hook and reckless behaviour by the banks will be seen to have been rewarded.

At the heart of the problem is that many of the most troubled assets are inherently illiquid and hard to price. The markets for many complex securities have dried up, so distress selling pushes prices to levels that exaggerate the losses on the underlying assets.

In theory, the US Treasury, in acting as 'market maker of last resort', should in itself boost confidence and thereby prices. But – at least initially – the incentive for others to buy these assets will be minimal.

The huge uncertainty about the prospects for the underlying assets also means that the banks’ offers in the reverse auctions could vary wildly, which will act as a deterrent for banks that place relatively high valuations on the securities involved.

Some commentators have suggested that one solution might be to offer the banks a share in the upside. To the extent that the assets were initially underpriced, good profits could be made once recovery takes hold and the assets mature.

However, there is little sign yet that this will be a feature of the Treasury’s bail out. To the extent that the initial price determines the eventual winners and losers, this process is liable to be long, drawn out and politically fraught. Indeed, that was the lesson of the Resolution Trust Corporation in the early 1990s.

How far will the government go?

Now that the US government is underwriting the system there should, in theory, be more interest from private and foreign suppliers of capital. But Cliffe said the price that the government offers for the toxic assets will affect the size of the capital hole that will need to be filled. This could leave some banks still needing government injections of capital to survive, he said.

Given the uncertainty about asset valuations, the scale of the required public recapitalisations is also in doubt, he said. 

Indeed, last week Senator Schumer advocated government provision of capital to the banks – rather than it buying the toxic assets – as based on the Reconstruction Finance Corporation of the 1930s. This would leave the banks with the task of managing and disposing of the toxic assets, limiting taxpayers' exposure.

Cliffe said there are also questions about what will happen to the capital bases of foreign financial institutions. Although, the US Treasury has indicated that it will allow them to participate in a programme of distressed assets through their foreign subsidiaries, Congress would certainly draw the line at US taxpayers supporting their recapitalisation.

Although the G7 finance ministers have said, 'We are ready to take whatever action may be necessary, individually or collectively, to ensure the stability of the international financial system,' there has hardly been a rush to put money on the table, Cliffe said.

Indeed, today's papers suggest that the European governments are unwilling to form their own rescue vehicle.

Support for US mortgage borrowers

Barney Frank, chairman of the House Financial Services Committee, has reportedly asked bankruptcy judges to make mortgage lenders change the terms of their loans in a bid to keep troubled borrowers in their homes.

Cliffe points out that Henry Paulson has already said he thinks there should be a mortgage relief component to the package.

Supporting the ailing banks will not in itself address the problem of the borrowers, Clifffe said, adding that moves to help borrowers, insofar as it cushioned the fall in house prices and scale of defaults, would help to support the toxic assets that are troubling the financial system.

But Cliffe points out that, as always, there remains the question of who picks up the bill. Direct fiscal support would put the burden on taxpayers.

In this respect, there must be doubts about the willingness and ability of the government to commit resources on a sufficient scale to materially alter the picture, he said.

Moreover, even if they did, some worry that trying to soften the blow in the housing market in this way might merely serve to prolong the agony by curtailing the necessary price adjustment.

Alternatively support for the borrowers could come from restructuring or renegotiating individual mortgages, but this might undermine the value of the distressed securities. This is where another Depression-era institution comes in.

The Home Owners’ Loan Corporation helped borrowers avoid foreclosure by refinancing mortgages with lower cost, longer-term mortgages.

Will regulations be softened?

There is a consensus now that this crisis stemmed in part from excessive leverage and inadequate capital in the financial system. However, the immediate danger is that the pressure to de-leverage and recapitalise the banking system will lead to a crippling credit contraction.

Although it will inevitably be seen as self-serving, the banks are, not surprisingly, calling for at least a temporary softening of the accounting and capital adequacy rules to give them a breathing space. However, the accounting bodies are digging in their heels.

Cliffe said the Financial Services Roundtable has already responded to the Treasury plan with a call for some of the rules for mortgage-related assets to be suspended, at least temporarily.

Likewise, he said, some questions have begun to emerge about the effect of the latest round of Basel II capital adequacy rules as these put downward pressure on the banks’ capital adequacy, forcing them to try to raise capital in a hostile market.

Cliffe said more clues as to the answers to these questions will emerge in the coming days as policy-makers know that they are working against the clock and that one false step could cause a financial cataclysm.

'In the light of this, the scale and range of the assistance that will be offered is likely to mount dramatically, rendering any forecast that we might make today irrelevant,' he said.