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Staggering, unprecedented, dramatic, transforming – analysts and headline writers have struggled for adjectives to characterize the $700 billion Wall Street bail-out plan Treasury Secretary Henry Paulson has unveiled in an effort to shore up the nation’s faltering financial markets.

Likened to Depression-era measures, the plan is breathtaking in its scope and its cost and in the dearth of detail contained in the draft legislation (a three-page document) seeking to implement it. The “Troubled Asset Relief Program” (TARP) gives the Treasury Department virtually unlimited authority to purchase up to $700 billion in “troubled assets” (broadly defined to include, in addition to mortgage securities, “other instruments originated or issued “after September 17th of this year) from eligible institutions, also broadly defined to include any institutions, including foreign-owned banks, with “significant operations in the United States.

In addition to the securities purchase plan, Treasury also announced that the government will temporarily insure the assets of money-market funds, a move designed to calm waters roiled after a major fund “broke the buck,” informing investors that its devalued assets could cover only 97 cents of every dollar invested.

In announcing the plan and urging speedy Congressional action to approve it, Paulson and Federal Reserve Chairman Ben Bernanke emphasized the need to address the crisis of confidence that they said threatens to freeze the credit markets and undermine the economy. “If [the financial system clogs up, this is going to have an adverse effect on peoples’ ability to get jobs, on their budgets, on their retirement savings, on lending for small business,” Paulson stated. The bail-out costs are high, he agreed, but “it will cost American families less than the alternative – a continuing series of financial institution failures and frozen credit markets,” shutting off the capital required for economic growth.

Congressional leaders emerged from a weekend briefing on the plan stunned and sobered by what they heard. “There was dead silence for 5 or 10 seconds,” Sen. Christopher Dodd (D-CT) told reporters. “The oxygen went out of the room.”

Legislators quickly caught their breath and found their voice, however, making it clear that while willing to move quickly and in a bi-partisan manner on the Paulson proposal, they were not willing to accept it without revisions. Democrats, led by Dodd and Rep. Barney Frank (D-MA), chairman of the House Financial Services Committee, are seeking more oversight of the securities purchase process, provisions that will clearly assist struggling homeowners, limits on executive compensation for any companies that participate in the program, and a change in the bankruptcy laws (which the Senate has defeated in the past) allowing bankruptcy judges to “cram down” the principal balance of home mortgages to reflect the reduced value of properties securing those loans. The bankruptcy and executive pay provisions are expected to encounter the most resistance from Paulson and Republicans.

Discussing the bankruptcy reform proposal on the Sunday talk shows, Paulson warned that making the bail-out program “too punitive” would discourage companies from using it and “it won’t work the way we need it to work.”

Frank insisted that the compensation cap is both appropriate and an essential component of the legislation. “It would be a grave mistake to say we’re going to buy up the bad debt that resulted from bad decisions these people [made] and then allow them to get unlimited money on the way out,” Frank said in an interview on Face the Nation.

As Congress prepares to debate the bail-out plan his week, it was clear that there was at least one aspect of the proposal that no one would question. It is the last line of the summary submitted to Congress, which says, “This is a draft and is expected to change.”

REVIVAL FOR DOWN PAYMENT ASSISTANCE

The seller-funded down payment program, which had all but received last rites, appears to have a chance of being revived. The House Financial Services Committee has approved a measure that would reverse a ban mandated by the housing rescue legislation Congress approved in August. The legislative ban prohibits the Federal Housing Administration (FHA) from insuring loans with the DPA feature, effectively killing the program, because the FHA guarantees most of these loans to low- and moderate-income buyers.

The FHA had sought the ban because of the out-sized losses on these loans. Claim rates average more than 28 percent, compared with 12 percent for other low-down-payment FHA loans, according to the Department of Housing and Urban Development (HUD). But the legislation lifting the ban on DPA programs will likely win HUD’s backing, the bill’s supporters say, because it tightens underwriting requirements and lifts the one-year moratorium the housing legislation imposed on the agency’s authority to use risk-based pricing.

“The FHA loved the ban on down payment assistance but hated the ban on risk-based pricing,” Rep. Barney Frank (D-MA), chairman of the House Financial Services Committee, said during the committee hearing at which he introduced the legislation rescuing the program. “That seemed to me to offer an opportunity.”

The legislation “replaces both bans with a middle ground,” Frank said. It allows the agency to charge higher insurance fees for borrowers with poor credit records, but requires the agency to refund some o the excess premiums if borrowers maintain a clean repayment record. To provide more safeguards for the FHA, the bill would allow borrowers with credit scores of 620 or higher to use the DPA program in conjunction with FHA-insured loans, but would require borrowers with scores between 620 and 680 to pay higher insurance premiums. The DPA ban would apply to borrowers with scores below 620 until the middle of next year, after which HUD could decide whether the program could be expanded without posing a risk to the FHA insurance fund.

Some press reports indicated that HUD Secretary Steve Preston supports the bill; others quoted HUD officials who said they had “deep reservations” about the measure. Frank said he has no reservations about the bill’s prospects. “It will pass the House, I can guarantee you,” he told legislators at the House hearing.
Whether the measure will pass the Senate, which inserted the DPA ban in the housing assistance bill to begin with, is another question. Although the bill lifting the ban won significant support from Republicans on the Financial Services Committee, GOP support was far from unanimous. Opponents included ranking member Spencer Bachus (R-AL), who noted the insurance losses related to DPA loans and argued that, given the current turmoil in the mortgage market, “it seems to me that this is the wrong time to reinstate the program.”

While opposition remains strong, there is no question that the nonprofit entities that broker the down payment assistance programs, and the home builders who have been relying on them increasingly, are gaining support as they emphasize the extent to which the loans have created home ownership opportunities for minorities and lower income borrowers.

The National Association of Home Builders (NAHB) has joined the Nehemiah Corporation of America, the largest DPA facilitator, in backing the effort to save the program, but Jerry Howard, the NAHB’s executive vice president and chief executive acknowledges that the prospects for action this year are “bleak.” Home builders and industry lobbyists are reaching out to legislators and to both the Republican and Democratic presidential campaigns, Howard told reporters, “to make sure we can move this bill early next session.”

In the meantime, home builders nationwide have been running ads warning prospective buyers that the DPA program will end October 1, and urging them to move quickly to purchase a home before that funding source “disappears.” According to industry statistics, 20 percent of new home buyers have used the program in recent years to overcome the down payment hurdle.

The impending end of that mechanism creates “a big incentive [for consumers] to buy now vs. later, when they most likely won’t have the [DPA] option,” Robert Curran, an analyst at Fitch Ratings, told USA Today. “It makes a lot of sense [for builders] to do promotions” around the issue, he added.

HOPE NOW AND THEN

HOPE Now, the coalition of lenders participating in the voluntary loan modification initiatives urged by the Treasury Department, reports that those efforts helped more than 2 million at risk borrowers avoid foreclosure during the last 13 months. Lenders “fixed” more than 192,000 loans in July alone, according to Hope Now statistics, a 6 percent increase over June and a one-month record for the coalition.

Even so, lenders are at best running in place against a still rising tide. More than 90,000 families lost their homes to foreclosure in July, more than double the year-ago number and a 4 percent increase over the June foreclosure total. “The treadmill is still going a little faster than [Hope Now] can keep up with,” Nicholas Retsinas, director of Harvard University’s Joint Center for housing Studies, told CNNMoney.com. “Foreclosures have outpaced the efforts to combat them,” he added.

The foreclosure pace continued to increase in August, when 304,000 homes were in some stage of foreclosure, according to RealtyTrac, which markets foreclosed properties on-line. That report and others provide statistical evidence of analysts’ projections that the foreclosure crisis would extend beyond the subprime market and engulf prime borrowers, as well. “We’ve been saying that the foreclosure trend has not yet peaked,” Doug Robinson, a spokesman for NeighborWorks America, a non-profit foreclosure prevention group, told CNNMoney. “Before, it was a subprime problem,” he noted. “Now, it’s everybody’s problem.”

WINNERS AND LOSERS

Before Treasury Secretary Henry Paulson announced what appears now to be “the mother of all bail-out plans,” the government take-over of Fannie Mae and Freddie Mac seemed to lay claim to that title. Analysts, who are now trying to calculate how many zeros this plan will add to the national debt, had been trying to sort out the winners and losers in the Fannie-Freddie restructuring. Their conclusions are worth noting, even though the GSE takeover no longer claims the front page spotlight. In the win column:

  • Holders of Fannie and Freddie bonds, whose positions are now secured by the government’s unlimited guarantee to back those securities. Much-relieved bond holders include central banks in Europe and Asia and large pension funds, whose financial stability would have been shaken badly had the GSEs defaulted on their mortgage-backed securities. Government intervention “takes that serious disruption to the financial markets off the table,” Mark Zandi, chief economist of Moody’s.com, told the Wall Street Journal.
  • The housing market, although to an uncertain degree. Mortgage rates have already declined and are expected to fall further, possibly spurring some home buying and mortgage refinancing activity. The takeover “goes a long way to stopping this housing deflation,” Bill Gross, chief investment officer of Pimco, a bond investment firm, told the Times. But the government action won’t address the overhang of unsold homes, job losses, and economic uncertainty, all of which are impeding a significant housing recovery. Whatever its beneficial effects on mortgage rates, a Times analysts concluded, the takeover of the GSEs “will probably do little to stop home prices from falling further and foreclosures are almost certain to rise.” Whether the government’s mega-plan to purchase under-water loans from weak financial institutions will have that desired effect – and how quickly -- remains to be seen. In the loss column for the Fannie-Freddie takeover, analysts noted the obvious.
  • Fannie and Freddie’s shareholders, whose stock has already lost 90 percent of its value and whose positions could be wiped out completely if Treasury exercises its option to purchase common stock. 
  • Commercial banks, savings institutions and other holders of preferred stock in the companies, whose pain could be significant and immediate if auditors require them to mark these positions down to their current (much reduced) market value. Banking industry regulators have indicated that they will work with affected institutions to help them develop capital restoration plans, if necessary. 
  • Taxpayers, who are on the hook for what could be substantial GSE losses. If the housing market recovers strongly and relatively quickly, the losses “could be in the low tens of billions, Clive Crook a Financial Times columnist, suggested. “If things keep getting worse, it could be in the hundreds of billions.”

FEDERAL PREEMPTION LIMITS

Unable to persuade the courts to limit federal preemption of state consumer protection laws, these three states have signed a compact, requiring the state-chartered banks they oversee to apply their home-state laws to operations in any of the other compact states. That means the branch of a New York state bank operating in New Jersey would be subject to New York’s consumer banking laws. Absent this agreement, banks expanding across state lines had the option of obeying regulations in the host state or converting from a state to a federal charter, carrying (in the view of most state regulators) fewer consumer protections.

“This agreement strengthens and streamlines our states’ regulation of banks and financial institutions and will enhance banks’ abilities to expand across state lines,” Steven Goldman, commissioner of New Jersey’s Department of Banking and Insurance, said. The agreement also represents “a very positive action for consumers and banks” in the compact states, he added.

New York Superintendent of Banks Richard Neiman cited additional benefits for the state banking charter and the regulatory system. The agreement “builds parity between state and national banks,” a “significant step,” Neiman said, “in retaining a competitive balance, which is the foundation of the dual banking system.”