Watered-Down Government Bailout Package Close To Completion

Although the bailout plan has not been finalized, lawmakers claim they will have a deal by Sunday night. The plan has been modified significantly from Paulson's original "Give me $700 Billion and don't ask any questions" proposal. You can read the full summary of the draft proposal on the Wall Street Journal's website. Some of the highlights include:

• Cuts the plan in half from original $700 billion, with congressional review required for more funding
• Gives taxpayers an ownership stake with participating companies
• Puts taxpayers first in line to recover assets if participating company fails
• Guarantees the taxpayers are repaid in full [intentionally vague?]
• Allows participation from pension plans, local governments and small banks
• Limits CEO compensation
• Recovers bonuses based on promised gains that later turn out to be false
• Allows government to facilitate mortgage modifications

This outline, which appears to offer significant protections to taxpayers, still lacks the necessary details related to pricing of the illiquid securities. After all, much disagreement exists over whether the goverment should pay "hold-to-maturity" prices versus "fair value." I suspect that allowing the government to take an ownership stake in the participating companies suggests that the government will pay above fair value prices for the illiquid assets, with expectations of making money on equity participation. The other key component is putting the government first in the recovery of assets if a participating company fails. It doesn't explain what sort of equity stake the government will take in pension plans or government organizations to help recoup potential losses from purchaing their illiquid assets. Furthermore, I don't understand why a pension plan (which should always hold assets to maturity) would need to sell assets at "distresses fire-sale" prices. But I digress...

I do think this is a much better plan for taxpayers, which frankly is a relief, because it means that my head won't explode from the recent accumulation of steam. However, since this is a financial market blog, I will focus on how I expect the near-inevitable passage of the bill to affect the markets and whether it will do anything to restore order to the chaotic credit markets.

I don't believe that this plan is what the credit markets were hoping for. Because of the government's ability to take a stake in the participating entities, only banks that are in serious trouble will want to participate. Solvent institutions will not want to dillute their equity holders and panic their debtholders. Because the government's equity participation will now supercede every other creditor in bankruptcy court, expect distress in bond prices of senior secured obligations of banks that need this plan to ditch troubled assets. My suspicion is that Wachovia's debt, already trading at depressed levels, will be distroyed on this news. Furthermore, I don't believe that the market will interpret $350 billion as a big enough fund to resolve what is most likely a trillion dollar problem. The Fed is already financing over $350 billion in dodgy assets for banks that cannot obtain financing elsewhere because of lack of transparent pricing and counterparty risk fears. This plan doesn't seem to provide reassurance that all of those fears are misplaced, particularly given the UK's nationalization of B&B over the weekend, Fortis Investment's possible nationalization by the Dutch, and Wachovia's desperation to find a suitor before the FDIC comes knocking. I know that some have been calling for a big relief rally on news of a bailout package, but I suspect if there is a rally, it will be shortlived as reality of the enormity of the situation sinks in.