Can Bailout Salve the Financials Woes?

Updated from 2:53 p.m. EDT.

Drastic steps outlined by U.S. regulators on Friday seemed to salve the wounds of the financial sector, which has been reeling from losses on bad loans for the past several months.

A temporary plan sketched out by the Treasury Department, Federal Reserve and Securities and Exchange Commission calmed a panic-stricken market, sending the Dow Jones Industrial Average up more than 4% early in the day. The steps include pouring hundreds of billions of dollars into the housing market, curbing short sales and supporting money-market funds.

Treasury Secretary Henry Paulson promised more comprehensive changes in the days and months ahead, but, as they say, the devil is in the details.

Paulson will be hammering out particulars over the weekend with Congress for a plan to remove illiquid assets from banks' books. Although he did not specifically mention a Resolution Trust Corp. structure, it is widely believed that a similar arrangement will take shape. The RTC served as a repository for failed banks' assets after the savings and loan crisis of the 1980s, but it's not clear how such a system would work in today's more complicated market.

Besides the typical hurdles for any legislation -- such as competing ideas and partisan bickering, particularly just two months ahead of a major election -- the financial landscape has changed dramatically since the first RTC was set up in 1989. That entity took over a wide variety of S&L assets, from office buildings and shopping centers, to loans, junk bonds and derivatives, but each asset was generally held by one entity. The bad assets of today consist mostly of securitized pools of loans owned by various parties across the globe, creating an even more complex puzzle for regulators to put their arms around.

"Can you put Humpty Dumpty back together, and if you can't, when you're looking at pools of pieces, how do you ascribe their value?" posits John D. Lyons, president and CEO of Savills, a global real-estate firm.

Lyons, who helped liquidate S&L assets the first time around, also fears that regulators may overstep their bounds in the private sector. Both Paulson and President George W. Bush said Friday that the government must intervene to prevent excessive risk-taking by financial institutions.

Paulson called the current regulatory structure "suboptimal, duplicative and outdated," saying that he had put forth his own ideas to Congress to modernize the system, but did not specify them. Bush, ordinarily a champion of laissez-faire governing in the capital markets, said such an approach can no longer work.

"Our system of free enterprise rests on the conviction that the federal government should interfere in the marketplace only when necessary," Bush said. "Given the precarious state of today's financial markets, and their vital importance to the daily lives of the American people, government intervention is not only warranted, it is essential."

But Lyons indicated that the government delving too far into the private sector could create a moral hazard and hinder economic growth, rather than support it.

"We live -- I should say, we lived -- in a free-market economy and that's part of what has made us great," says Lyons. "There's going to have to be a delicate balance between under and over-regulation."

James Angel, an associate professor of finance at Georgetown University, was also cautious about the hurried plan, whose details have been sparse thus far. While members of Congressional banking committees initially said that no plans would come to fruition until after the November elections, by Friday the timeline shrunk to three days from two months.

"Before the election, I'm really skeptical of anything that comes out of any side of the aisle in Washington," says Angel. "Everybody wants to do something in light of the crisis, and I'm concerned that any of the plans coming forth are half-baked."

Paulson also said the plan will add hundreds of billions of dollars worth of debt to the U.S. balance sheet. While Bush and Paulson noted the "significant" taxpayer burden, they warned that inaction could further cripple the economy in terms of jobs, wealth and lending.

And while the risk and cost to taxpayers seems large, it is possible that all the debts will be repaid and might even earn money in the long run, much like the initial RTC. The vast majority of homeowners are still making good on mortgage payments. In theory, the measures would also help normalize the markets by assigning values to illiquid assets and pushing bad loans to perform once again.

So far investors, if not taxpayers, seem confident that lawmakers and regulators will be able to hammer out an adequate solution. The markets rallied on Thursday and Friday, after a depressing string of events this year that caused the collapse, bailout or takeover of top financial firms, including Bear Stearns, Fannie Mae ( FNM), Freddie Mac ( FRE), AIG ( AIG), Lehman Brothers and Merrill Lynch ( MER).

Whatever plan comes into being is likely to be a positive for the remaining banks, who will be able to unload their toxic assets. It may also prevent financials whose fate seemed uncertain this week -- such as Goldman Sachs ( GS), Morgan Stanley ( MS), Washington Mutual ( WM) and Wachovia ( WB) -- from entering shotgun marriages at depressed values. All of those stocks gained more than 20% on Friday, with WaMu soaring more than 40%.

However, bottom-feeding investors may have longer to wait. Morgan Keegan analyst Robert Patten notes that after the S&L meltdown, bank valuations did not stop dropping until four quarters after the RTC was formed, while delinquencies and charge-offs peaked about six to eight quarters later.

Still, an RTC structure would certainly provide a lifeline for many banks. Instead of focusing on bad assets, Patten writes, they could "shift focus on the core earnings power and the franchise value."

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