Congressional Budget Office
Douglas W. Elmendorf
Director’s Blog

CBO has released a cost estimate for H.R. 1, the American Recovery and Reinvestment Act of 2009, which was introduced today in the House of Representatives. A link to the full cost estimate can be found here.

As summarized in the cost estimate, H.R. 1 would specify appropriations for a wide range of federal programs and would increase or extend certain benefits payable under the Medicaid, unemployment compensation, and nutrition assistance programs. The legislation also would reduce individual and corporate income tax collections and make a variety of other changes to tax laws.

Assuming enactment in mid-February, CBO estimates that the bill would increase outlays by $92 billion during the remaining several months of fiscal year 2009, by $225 billion in fiscal year 2010 (which begins on October 1), by $159 billion in 2011, and by a total of $604 billion over the 2009-2019 period. That spending includes outlays from discretionary appropriations in Division A of the bill and direct spending resulting from Division B.

In addition, CBO and the Joint Committee on Taxation (JCT) estimate that enacting the provisions in Division B would reduce revenues by $76 billion in fiscal year 2009, by $131 billion in fiscal year 2010, and by a net of $212 billion over the 2009-2019 period.

In combining the spending and revenue effects of H.R. 1, CBO estimates that enacting the bill would increase federal budget deficits by $169 billion over the remaining months of fiscal year 2009, by $356 billion in 2010, by $174 billion in 2011, and by $816 billion over the 2009-2019 period.

The budgetary impact of the bill stems primarily from three types of transactions: Direct payments to individuals (such as unemployment benefits), reductions in federal taxes, and purchases of goods and services (either by the federal government directly or indirectly via grants to states and local governments). CBO estimates that impacts from the first two categories of transactions would occur fairly rapidly. In the third category, CBO estimates slower rates of spending than historical full-year spending rates in 2009 for a number of reasons:

• The bill’s enactment would likely occur nearly half way through the fiscal year.
• Previous experience suggests that agencies have difficulty rapidly expanding existing programs while maintaining current services; the funding in H.R. 1 for some programs is substantially greater than the usual annual funding for those activities.
• Spending can be delayed by necessary lags for planning, soliciting bids, entering contracts, and conducting regulatory or environmental reviews.
• Agencies face additional challenges in spending funds for new programs quickly because of the time necessary to develop procedures and criteria, issue regulations, and review plans and proposals before money can be distributed.

Frequently in the past, in all types of federal programs, a noticeable lag has occurred between sharp increases in funding and resulting increases in outlays. Based on such experiences, CBO expects that federal agencies, states, and other recipients of funding would find it difficult to properly manage and oversee a rapid expansion of existing programs so as to spend added funds quickly as they expend their normal resources. The seasonal nature of some spending also affects the speed at which activities can be conducted; for example, major school repairs are generally scheduled during the summer to avoid disrupting classes.

The following table summarizes CBO’s and JCT’s estimates of the budget effects of H.R. 1.

This is the first cost estimate that CBO has prepared for H.R. 1 in its entirety. A previous preliminary estimate that has been widely cited addressed only the budgetary impacts of an earlier version of the provisions contained in Division A, at the request of the House Committee on Appropriations. 

CBO has since made small changes to our estimates of the portion of the bill that was included in that preliminary estimate, mostly to reflect amendments to the legislation since we prepared the last estimate. Based on information provided by the committee and discussions with numerous state officials, we also made small technical changes to that earlier estimate.  

Yesterday’s testimony on the effects of recent financial market turmoil on pension assets has generated a significant amount of interest, so I wanted to follow up on one topic: overinvestment in an employer’s stock.

Many participants in retirement plans appear to be taking on unnecessary risk by investing in individual stocks rather than a diversified portfolio. The result is that those workers assume excessive risk for which they do not receive a higher expected return. (Those workers may feel they have inside information or insights that will allow them to outperform the market with particular investment choices, but the evidence suggests that unless you’re Warren Buffett, trying to outguess the market usually doesn’t work.)  Investing excessively in one stock that also happens to be your employer’s stock is even riskier — if the company runs into trouble, both your retirement assets and your job may be in danger.

Despite those risks (again, for which workers don’t receive higher expected returns on their investments, on average), a significant number of 401(k) participants hold the bulk of their assets in company stock. According to calculations by the Employee Benefits Research Institute, 47 percent of 401(k) participants were enrolled in plans that offered company stock as an option as of the end of 2006. Of those participants, 7.3 percent held more than 90 percent of their assets in company stock, and over 15 percent held over half their assets in company stock. (See page 33 of EBRI Issue Brief 308, “401(k) Asset Allocation, Account Balances, and Loan Activity in 2006.”) At yesterday’s hearing, I didn’t make clear that the 7.3 percent figure applied only to those who were in plans offering company stock. So the overall share of 401(k) participants with 90 percent or more of their assets invested in company stock is more like .47*7.3=3.4 percent. It’s still too high.

The good news is that the trend is towards less investment in company stock. For example, in 1999 EBRI estimated that 19.1 percent of all 401(k) assets were held in company stock. (See figure 20 on page 26 of EBRI issue brief 308.) By 2006, that share had fallen to 11.1 percent, undoubtedly driven in part by the example of the collapse of Enron and other corporate failures. In addition, provisions of the Pension Protection Act of 2006 limit the amount of time that an employer may insist participants keep assets in company stock.

Despite these auspicious trends, there remains substantial scope to improve the balance of risk and return for participants in defined-contribution pension plans, including through increased use of low-cost diversified index funds.

I am testifying before the House Committee on Education on Labor this afternoon on the effects of recent financial market developments on pensions; click here for the testimony.

The key points of the testimony include:

• The turmoil in financial markets has affected many aspects of the economy, including pensions. The most direct effect on pensions is through the prices of financial assets such as corporate equities and bonds. The Standard & Poor’s 500 stock market index, for example, has fallen by more than 25 percent over the past year as the outlook for the economy and corporate profits has worsened. Because the majority of pension assets are held in equities, drops in stock prices have had a significant adverse effect on pension plans.

• Data from the Federal Reserve suggest that the decline in the value of financial assets cost pension funds roughly $1 trillion—almost 10 percent of their assets—from the second quarter of 2007 to the second quarter of 2008, the latest period for which data are available. There has been a significant further drop in asset prices since the end of the second quarter, and it is plausible that the cumulative decline in pension assets over the past year and a half amounts to about $2 trillion.

• In a defined-benefit pension plan, benefits are specified by a fixed formula unrelated to the value of the pension fund. The sponsor of the plan is generally responsible for financing the benefits and must therefore make larger contributions when the value of the assets held by the pension fund declines. By CBO’s estimates, the value of the assets held by defined-benefit plans has declined by roughly 15 percent over the past year. Because of the way the obligations of the plans are calculated, their funding position (that is, the relationship between their assets and liabilities) is also affected by the level of interest rates. Those rates have increased over the past year, lowering the discounted value of plans’ liabilities by roughly 5 percent to 10 percent and partially offsetting the drop in asset values. Overall, according to CBO’s estimates, defined-benefit plans’ assets net of liabilities may have decreased by 5 percent to 10 percent over the past year.

• Changes in asset prices have also affected the value of assets in defined-contribution pension plans. In those plans, the resources available to workers upon retirement depend directly on the value of assets in their plan account. Defined-contribution plans apparently are more heavily weighted toward stocks than defined-benefit plans are; over two-thirds of the assets in defined-contribution plans are invested in equities (either directly or through mutual funds). Because of that heavy emphasis on equities, the value of assets in defined-contribution plans may have declined by slightly more than that of assets in defined-benefit plans.

• Some people on the verge of retirement might respond to a decline in financial markets by working longer. In 2006, 36 percent of people age 65 and older were in families with earnings; that share could rise somewhat over the next few years, both because of underlying trends in the labor market and because of the recent turmoil in financial markets.

• Although severe stresses in financial markets almost inevitably cause wrenching adjustments by workers and employers, the risks can be attenuated by sensibly designing pension plans. For example, although workers enrolled in defined-contribution plans may not be able to avoid bearing the risks associated with broad price changes in financial markets, they can avoid unnecessary risks associated with a lack of diversification. Such unnecessary risks can arise, for example, by overweighting portfolios with individual stocks rather than diversified index funds.

CBO released a brief today on climate-change policy and CO2 emissions from passenger vehicles (for the PDF, click here).

Discussions about addressing climate change (e.g., through a cap-and-trade program or a carbon tax) often focus on the transportation sector. The brief argues, however, that most of the reduction in CO2 emissions would occur in other sectors (e.g., the electricity sector) and that the effects on vehicle emissions would be modest, especially in the shorter run.

To be sure, a cap-and-trade system or a carbon tax would raise the price of gasoline, encouraging consumers to drive less and to buy more fuel-efficient cars– but the magnitude of these effects would be relatively small. For example, CBO has estimated that a price of $28 per metric ton of CO2 in 2012 would lead to a reduction of about 10 percent in total U.S. emissions compared with a no-action scenario. Vehicle emissions, though, would remain relatively constant in the short run, and even over time they would decline only by around 2.5 percent — much less than the 10 percent reduction in overall emissions.

Several factors account for the relatively small influence that a price on CO2 emissions would have on passenger vehicles and driving behavior. First, a CO2 price of $28 per metric ton would raise gas prices by about 25 cents per gallon, far less of an increase than consumers have recently born with little behavioral result. (Between 2003 and 2007, gas prices increased from $1.50 to more than $3.00 per gallon. Vehicle miles driven, driving speeds, and the purchase of larger vehicles have all responded only modestly despite the dramatic increase in prices.) An increase in gas prices of 25 cents or so per gallon is unlikely to generate massive changes in driving behavior.

In addition, recent changes to corporate average fuel economy (CAFE) standards will require substantial gains in fuel economy over the next dozen years. Especially over the longer term, gas price increases are not likely to have a large effect beyond what CAFE standards will require.

Finally, cultural, historic, and geographic considerations drive the extent to which Americans have become dependent on automobile travel, and their choices tend towards larger and more powerful (and less fuel efficient) automobiles. While dramatic increases in gasoline prices (or shifts in cultural norms) might eventually influence these considerations, the magnitude of gas price increases under most legislation under consideration would likely have little effect.

The brief was written by David Austin of our Microeconomic Studies Division.

CBO has just issued its analysis of the financial rescue legislation released by the Senate today. This legislation includes the rescue package considered by the house earlier this week, a temporary increase in deposit insurance, and certain tax provisions including an extension of Alternative Minimum Tax (AMT) relief. The pdf of our analysis is posted here. The text of our analysis is pasted below.

October 1, 2008

Honorable Christopher J. Dodd
Chairman
Committee on Banking, Housing, & Urban Affairs
United States Senate
Washington, DC  20510

Dear Mr. Chairman:

The Congressional Budget Office (CBO) has reviewed the financial rescue legislation to be considered by the Senate.  That legislation contains three separate parts; the bill refers to these three components as “divisions.”

Division A is the Emergency Economic Stabilization Act of 2008, most of which is identical to the financial rescue bill considered by the House of Representatives earlier this week.  In addition to creating a Troubled Asset Relief Program (TARP), under which the Secretary of the Treasury would be authorized to purchase, insure, hold, and sell a wide variety of financial instruments, particularly those that are based on or related to residential or commercial mortgages issued prior to March 14, 2008, Division A also includes a provision that would provide for a temporary increase in federal deposit insurance coverage.

Division B is entitled the Energy Improvement and Extension Act of 2008. It contains numerous tax provisions related to energy production, transportation, and energy conservation.  Division C extends various expiring tax provisions, including alternative minimum tax relief.

Although significant uncertainty surrounds the precise net budgetary impact from Division A of the bill, CBO expects that the bill as a whole (including Divisions B and C) would increase the budget deficit over the next decade.

Division A – Emergency Economic Stabilization Act of 2008

In addition to the TARP, the Senate legislation includes an expansion in deposit insurance.   This section describes and analyzes the provisions of Division A, beginning with the changes to deposit insurance.

Deposit Insurance

Section 136 would provide for a temporary increase in the amount of deposits insured by the Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration (NCUA), raising the limit for each insured account from $100,000 to $250,000 through December 31, 2009. Both agencies would be authorized to borrow such sums as may be necessary to cover any additional costs incurred as a result of the expanded coverage.  The legislation also directs the agencies to exclude the increase in insurance coverage when assessing insurance premiums in the near term.

CBO estimates that the deposit insurance funds would incur larger losses in the near term as a result of higher coverage levels and the associated increase in insured deposits.  (When institutions fail, the FDIC and NCUA pay for covered deposits and liquidate the assets held by the institution.  Raising the amount of insured deposits would increase payments to depositors without affecting recoveries from liquidating assets, thereby increasing the net loss to the funds.)  Such near-term losses would, however, be offset over the long term by higher insurance premiums because the agencies are required by law to restore the deposit insurance funds to certain levels over time, so any additional losses from the temporary expansion in coverage will gradually be offset by higher future premiums.

The effects of this provision on outlays over the next year or two are difficult to predict precisely because of uncertainty about the volume and distribution of insured deposits that would be added by this bill. Based on preliminary information from the FDIC, however, CBO estimates that raising the limit to $250,000 through 2009 would boost insured deposits nationwide by about 15 percent.  (As of June 30, 2008, deposits at FDIC-insured institutions totaled about $7 trillion, of which $2.6 trillion were uninsured.  The FDIC estimate suggests that this provision would extend coverage to about $700 billion of those uninsured deposits.)

Overview of TARP

The bill would appropriate such sums as are necessary, for as many years as necessary, to enable the Secretary to purchase or insure troubled assets and to cover all administrative expenses of purchasing, insuring, holding, and selling those assets.  Under the legislation, the authority to enter into agreements to purchase such troubled assets would initially be set to expire on December 31, 2009, but could be extended through two years from the date of enactment upon certification by the Secretary that such an extension is necessary.  The purchase price of all such assets outstanding at any one time could not exceed $700 billion (though cumulative gross purchases could exceed $700 billion as previously purchased assets are sold).  Purchases would be limited as follows:

-Authority for purchases of $250 billion in assets would be available upon enactment;

-The authority would increase to $350 billion if the President submits to the Congress a written notification that the Secretary is exercising authority to purchase an additional $100 billion of assets; and

-The authority would increase to $700 billion if the President submits a report detailing a plan to use the remaining $350 billion in purchase authority; that expansion would be subject to a 15-day Congressional review for potential disapproval of the plan.

The bill would also enable the federal government, under terms and conditions to be developed by the Secretary of the Treasury, to insure troubled assets, including mortgage-backed securities, and collect premiums from participating financial institutions.  The $700 billion limit would be reduced by the excess of obligations to net premiums, if any, under this insurance program.

To facilitate these activities, the federal debt limit would be increased by $700 billion. If, five years after enactment of the bill, the Director of the Office of Management and Budget in consultation with the Director of the Congressional Budget Office determines that the TARP has incurred a net loss, the President would be required to submit a legislative proposal to recoup that shortfall from entities benefiting from the TARP.

Cost of Division A

Under the TARP, the Secretary would have the authority—if deemed necessary to promote stability in the financial markets—to purchase any financial asset at any price and to sell that asset for any price at any future date. That lack of specificity regarding how the authority would be implemented and even what types of assets would be purchased makes it impossible at this point to provide a meaningful estimate of the ultimate impact on the federal budget from enacting this legislation. Although it is not currently possible to quantify the net budget impact given the lack of details about how the program would be implemented, CBO has concluded that enacting Division A would likely entail some net budget cost—which would, however, be substantially smaller than $700 billion. The net budget cost would reflect several factors:

Net gains or losses on the TARP transactions. As noted in CBO’s recent testimony before the House Budget Committee, the net gain or loss on the TARP transactions would reflect the degree to which the federal government sought to obtain, and succeeded in receiving, a fair market price for the assets it purchased, and the degree to which, because of severe market turmoil, market prices would be lower than the underlying value of the assets.

Although some classes of assets and purchase mechanisms are conducive to determining a fair market price, it is unlikely that the program would be limited exclusively to those classes of assets and purchase mechanisms. The program would probably include assets that have the worst credit risks and hence are difficult to price, making it likely that the government would, in some cases, pay prices that fail to cover those risks. Although it is possible that future increases in asset values would generate gains even on assets for which the government initially overpays, an overall net loss is more likely if the government initially overpays.

The bill includes a provision intended to protect against such future net losses by requiring that firms selling troubled assets to the government also provide warrants or senior debt instruments.  CBO anticipates that this provision would not have a substantial effect on the net cost of the TARP, however.  On the one hand, warrants or senior debt instruments might reduce the incentive for sellers to overcharge for low-quality assets.  On the other hand, since the warrants or debt instruments would have value, Treasury would generally face higher prices because sellers would seek compensation for both the value of the troubled asset and the value of the warrant or debt instrument.  In addition, the warrants or senior debt instruments may be difficult for the government to value, complicating even those auctions in which the government is otherwise most likely to obtain a fair market price.

In any case, the ultimate cost to the government on the transactions would not be the total amount spent to purchase assets—limited to $700 billion outstanding at any one time—but rather the difference between the amount spent by the government and the amount received in earnings and sales proceeds when all of the assets are finally sold, presumably some years from now. That net cost is likely to be substantially less than $700 billion but is more likely than not to be greater than zero.

Recoupment mechanism. The recoupment mechanism is designed to offset any net losses the government experiences on the TARP transactions. The mechanism, however, requires only that the President submit a proposal to offset such costs after five years. Even if it would be fully effective in offsetting any net losses, the President’s proposal would require a future act of Congress to be implemented. Any savings from such legislation would be estimated when the proposal is considered and would be credited to that legislation for Congressional scorekeeping purposes.

Administrative costs. Beyond the effect of any gains or losses on the transactions under the TARP and the recoupment mechanism, the programs authorized by this bill would involve administrative costs. For example, the government would have to compensate the private asset managers hired by the Treasury. Those administrative costs are not included in the $700 billion limit on asset purchases. Even if the transactions and the recoupment mechanism combined resulted in neither a gain nor a loss for the government, the administrative costs would expand the budget deficit.

The legislation includes a variety of other provisions that would, on net, add to the budget deficit. A number of those provisions are discussed below.

Other Major Provisions of Division A

In addition to the expansion in FDIC insurance limits and the provisions of the TARP discussed above, Division A also contains provisions that would:

-Change the tax treatment of certain types of income, losses, or deductions of corporations or individuals;

-Require that certain financial institutions seeking to sell assets through the TARP meet appropriate standards for senior executive officers’ compensation, as determined by the Secretary of the Treasury;

-Require the Secretary of the Treasury to take steps to maximize assistance for homeowners, including encouraging servicers of the underlying mortgages to take advantage of the Hope for Homeowners Program under section 257 of the National Housing Act;

-Allow the Federal Reserve System to pay interest on certain reserves of depository institutions that are held on deposit at the Federal Reserve, starting on October 1, 2008;

-Direct the Federal Housing Finance Agency, the Federal Deposit Insurance Corporation, and the Federal Reserve Board to implement various measures with regard to residential loans and securities under their control in order to reduce the number of foreclosures, which could include modifying the terms of such loans; and

-Establish Congressional oversight and reporting requirements related to implementation of the legislation, along with a Financial Stability Oversight Board with responsibility for overseeing operations of the program.

The bill would require that the federal budget display the costs of purchasing or insuring troubled assets using procedures similar to those specified in the Federal Credit Reform Act, but adjusting for market risk (in a manner not reflected in that law). In particular, the federal budget would not record the gross cash disbursements for purchases of troubled assets (or cash receipts for their eventual sale), but instead would reflect the estimated net cost to the government of such purchases (broadly speaking, the purchase cost minus the present value, adjusted for market risk, of any estimated future earnings from holding those assets and the proceeds from the eventual sale of them).

Impact on Federal Finances

CBO expects that the Treasury would use most or all of the $700 billion in purchase authority within two years (after which the authority to enter into agreements to purchase various troubled assets would expire). To finance those purchases, the Treasury would have to sell debt to the public. Federal debt held by the public would therefore rise by about $700 billion, although the government would also acquire valuable financial assets in the process.  As noted above, CBO expects that since the acquired assets would have some value, the net budget impact would be substantially less than $700 billion; similarly, net cash disbursements under the program would also be substantially less than $700 billion over time because, ultimately, the government would sell the acquired assets and thus generate income that would offset much of the initial expenditures.

In addition to any net gain or loss on the purchase of $700 billion or more in assets, the government also would incur administrative costs for the proposed program. Those costs would depend on the kinds of assets purchased or insured. On the basis of the costs incurred by private investment firms that acquire, manage, and sell similar assets, CBO expects that the administrative costs of operating the program could amount to a few billion dollars per year, as long as the government held all or most of the purchased assets.

Other provisions in Division A would on net increase the budget deficit.  For example, the legislation would allow the Federal Reserve to pay interest immediately on certain reserve balances of depository institutions, rather than starting on October 1, 2011, as allowed under current law.  CBO estimates that, over the next three years, the provision would reduce the Federal Reserve’s payments of its profits to the Treasury, which are classified as revenue in the federal budget.

In addition, a number of provisions Division A would affect federal revenues by changing tax law, including provisions that would limit the deductibility of executive compensation for certain firms selling assets; allow losses incurred by certain taxpayers on preferred stock in Fannie Mae and Freddie Mac to be treated as ordinary rather than capital losses; and exclude from income amounts attributable to the cancellation of mortgage debt of individuals in certain circumstances. The Joint Committee on Taxation estimates that, on net, these provisions in Division A would reduce federal revenues.

Enacting Division A could also affect other federal spending—including, for example, outlays from the operations of Fannie Mae, Freddie Mac, federal housing programs, and deposit insurance. Some of those effects would be related to how TARP would be used to purchase assets (including what kinds of assets would be acquired and from what types of institutions), and how successful the program would be in restoring liquidity to the nation’s financial markets.

Division B – Energy Improvement and Extension Act of 2008

Division B of the bill would provide a number of tax incentives related to energy and fuel production and energy conservation.  It also includes several provisions that would raise revenue, with the largest effect from a modification of the requirements imposed on brokers for the reporting of their customers’ basis in securities transactions.  CBO and the Joint Committee on Taxation (JCT) estimate that, over the 2009-2013 period, Division B would reduce revenues by $6.8 billion, increase outlays by about $0.2 billion, and increase projected deficits by about $7 billion.  CBO and JCT estimate that, over the 2009-2018 period, Division B would increase revenues by about $0.3 billion, increase outlays by about $0.2 billion, and reduce projected deficits by less than $0.1 billion.

Division C – Tax Extensions and Alternative Minimum Tax Relief

Division C would extend relief from the alternative minimum tax for 2008, extend and modify a number of other expiring tax provisions, provide tax relief for regions of the country affected by severe storms earlier this year, make other changes to tax law, and provide payments to state and local governments for support to rural schools and other county programs.  It also would modify the tax treatment of deferred compensation paid by certain foreign entities.  CBO and JCT estimate that, over the 2009-2013 period, Division C would reduce revenues by about $105.2 billion, increase outlays by $7.1 billion, and increase projected deficits by about $112.3 billion.  CBO and JCT estimate that, over the 2009-2018 period, Division C would reduce revenues by about $99.5 billion, increase outlays by about $7.5 billion, and increase projected deficits by about $107.1 billion.

Intergovernmental and Private-Sector Mandates

The non-tax provisions of the legislation contain no intergovernmental mandates as defined in the Unfunded Mandates Reform Act (UMRA).

The non-tax provisions do, however, contain private-sector mandates as defined in UMRA, and CBO estimates that the aggregate cost of those mandates would exceed the annual threshold established in UMRA ($136 million in 2008, adjusted annually for inflation).

Division C, section 512 would impose a private-sector mandate on group health plans and issuers of group health insurance by prohibiting them from imposing treatment limitations or financial requirements for mental health benefits that differ from those placed on medical and surgical benefits. CBO estimates that the direct costs of the private-sector mandate would significantly exceed the annual threshold established in UMRA in each of the first five years that the mandate would be in effect.

Division A, section 136 could impose a private-sector mandate to the extent that deposit insurance premiums are higher than they would be in the absence of  this bill. Most depository institutions (commercial banks, savings associations, and credit unions) are required by law to have federal deposit insurance. CBO, therefore, considers changes in the federal deposit insurance system that increase requirements on those institutions to be private-sector mandates under UMRA. The cost of the mandate would be the additional premiums assessed during each of the first five years the mandate is in effect. While CBO expects that any additional losses from the temporary expansion in coverage would gradually be offset by higher future premiums, we cannot estimate the cost of the mandate because of uncertainty about the timing of the losses and whether or by how much premiums would increase during those first five years.

I hope this information is helpful to you. If you have further questions about CBO’s analysis, do not hesitate to contact me.

Sincerely,

Peter R. Orszag
Director

cc:

Honorable Richard C. Shelby
Ranking Member

Honorable Kent Conrad
Chairman
Committee on the Budget

Honorable Judd Gregg
Ranking Member

Honorable Max Baucus
Chairman
Committee on Finance

Honorable Charles E. Grassley
Ranking Member

CBO has just issued its analysis of the Emergency Economic Stabilization Act of 2008, as released tonight by the House Committee on Financial Services. Among other provisions, the legislation would create a Troubled Asset Relief Program (TARP). The pdf of our analysis is posted here. The text is pasted below.

—

September 28, 2008

Honorable Barney Frank
Chairman
Committee on Financial Services
U.S. House of Representatives
Washington, DC 20515

Dear Mr. Chairman:

The Congressional Budget Office (CBO) has reviewed the Emergency Economic Stabilization Act of 2008, as released by the House Committee on Financial Services on September 28, 2008. The legislation would, among other provisions, create a Troubled Asset Relief Program (TARP), under which the Secretary of the Treasury would be authorized to purchase, insure, hold, and sell a wide variety of financial instruments, particularly those that are based on or related to residential or commercial mortgages issued prior to March 14, 2008. Under the legislation, the authority to enter into agreements to purchase such troubled assets would initially be set to expire on December 31, 2009, but could be extended through two years from the date of enactment upon certification by the Secretary that such an extension is necessary.

The bill would appropriate such sums as are necessary, for as many years as necessary, to enable the Secretary to purchase or insure troubled assets and to cover all administrative expenses of purchasing, insuring, holding, and selling those assets. The purchase price of all such assets outstanding at any one time could not exceed $700 billion (though cumulative gross purchases could exceed $700 billion as previously purchased assets are sold). Purchases would be limited as follows:

- Authority for purchases of $250 billion in assets would be available upon enactment;

- The authority would increase to $350 billion if the President submits to the Congress a written notification that the Secretary is exercising authority to purchase an additional $100 billion of assets; and

- The authority would increase to $700 billion if the President submits a report detailing a plan to use the remaining $350 billion in purchase authority; that expansion would be subject to a 15-day Congressional review for potential disapproval of the plan.

The bill would also enable the federal government, under terms and conditions to be developed by the Secretary of the Treasury, to insure troubled assets, including mortgage-backed securities, and collect premiums from participating financial institutions. The $700 billion limit would be reduced by the excess of obligations to net premiums, if any, under this insurance program.

To facilitate these activities, the federal debt limit would be increased by $700 billion. If, five years after enactment of the bill, the Director of the Office of Management and Budget in consultation with the Director of the Congressional Budget Office determines that the TARP has incurred a net loss, the President would be required to submit a legislative proposal to recoup that shortfall from entities benefiting from the TARP.

Cost of the Legislation

Under the TARP, the Secretary would have the authority—if deemed necessary to promote stability in the financial markets—to purchase any financial asset at any price and to sell that asset for any price at any future date. That lack of specificity regarding how the authority would be implemented and even what types of assets would be purchased makes it impossible at this point to provide a meaningful estimate of the ultimate impact on the federal budget from enacting this legislation. Although it is not currently possible to quantify the net budget impact given the lack of details about how the program would be implemented, CBO has concluded that enacting the bill would likely entail some net budget cost—which would, however, be substantially smaller than $700 billion. The net budget cost would reflect several factors:

Net gains or losses on the TARP transactions. As noted in CBO’s recent testimony before the House Budget Committee, the net gain or loss on the TARP transactions would reflect the degree to which the federal government sought to obtain, and succeeded in receiving, a fair market price for the assets it purchased, and the degree to which, because of severe market turmoil, market prices would be lower than the underlying value of the assets.

Although some classes of assets and purchase mechanisms are conducive to determining a fair market price, it is unlikely that the program would be limited exclusively to those classes of assets and purchase mechanisms. The program would probably include assets that have the worst credit risks and hence are difficult to price, making it likely that the government would, in some cases, pay prices that fail to cover those risks. Although it is possible that future increases in asset values would generate gains even on assets for which the government initially overpays, an overall net loss is more likely if the government initially overpays.

The bill includes a provision intended to protect against such future net losses by requiring that firms selling troubled assets to the government also provide warrants or senior debt instruments. CBO anticipates that this provision would not have a substantial effect on the net cost of the TARP, however. On the one hand, warrants or senior debt instruments might reduce the incentive for sellers to overcharge for low-quality assets. On the other hand, since the warrants or debt instruments would have value, Treasury would generally face higher prices because sellers would seek compensation for both the value of the troubled asset and the value of the warrant or debt instrument. In addition, the warrants or senior debt instruments may be difficult for the government to value, complicating even those auctions in which the government is otherwise most likely to obtain a fair market price.

In any case, the ultimate cost to the government on the transactions would not be the total amount spent to purchase assets—limited to $700 billion outstanding at any one time—but rather the difference between the amount spent by the government and the amount received in earnings and sales proceeds when all of the assets are finally sold, presumably some years from now. That net cost is likely to be substantially less than $700 billion but is more likely than not to be greater than zero.

Recoupment mechanism. The recoupment mechanism is designed to offset any net losses the government experiences on the TARP transactions. The mechanism, however, requires only that the President submit a proposal to offset such costs after five years. Even if it would be fully effective in offsetting any net losses, the President’s proposal would require a future act of Congress to be implemented. Any savings from such legislation would be estimated when the proposal is considered and would be credited to that legislation for Congressional scorekeeping purposes.

Administrative costs. Beyond the effect of any gains or losses on the transactions under the TARP and the recoupment mechanism, the programs authorized by this bill would involve administrative costs. For example, the government would have to compensate the private asset managers hired by the Treasury. Those administrative costs are not included in the $700 billion limit on asset purchases. Even if the transactions and the recoupment mechanism combined resulted in neither a gain nor a loss for the government, the administrative costs would expand the budget deficit.

The legislation includes a variety of other provisions that would, on net, add to the budget deficit. A number of those provisions are discussed below.

Other Major Provisions

The bill also contains provisions that would:

- Change the tax treatment of certain types of income, losses, or deductions of corporations or individuals;

- Require that certain financial institutions seeking to sell assets through the TARP meet appropriate standards for senior executive officers’ compensation, as determined by the Secretary of the Treasury;

- Require the Secretary of the Treasury to take steps to maximize assistance for homeowners, including encouraging servicers of the underlying mortgages to take advantage of the Hope for Homeowners Program under section 257 of the National Housing Act;

- Allow the Federal Reserve System to pay interest on certain reserves of depository institutions that are held on deposit at the Federal Reserve, starting on October 1, 2008;

- Direct the Federal Housing Finance Agency, the Federal Deposit Insurance Corporation, and the Federal Reserve Board to implement various measures with regard to residential loans and securities under their control in order to reduce the number of foreclosures, which could include modifying the terms of such loans; and

- Establish Congressional oversight and reporting requirements related to implementation of the legislation, along with a Financial Stability Oversight Board with responsibility for overseeing operations of the program.

The bill would require that the federal budget display the costs of purchasing or insuring troubled assets using procedures similar to those specified in the Federal Credit Reform Act, but adjusting for market risk (in a manner not reflected in that law). In particular, the federal budget would not record the gross cash disbursements for purchases of troubled assets (or cash receipts for their eventual sale), but instead would reflect the estimated net cost to the government of such purchases (broadly speaking, the purchase cost minus the present value, adjusted for market risk, of any estimated future earnings from holding those assets and the proceeds from the eventual sale of them).

Impact on Federal Finances

CBO expects that the Treasury would use most or all of the $700 billion in purchase authority within two years (after which the authority to enter into agreements to purchase various troubled assets would expire). To finance those purchases, the Treasury would have to sell debt to the public. Federal debt held by the public would therefore rise by about $700 billion, although the government would also acquire valuable financial assets in the process. As noted above, CBO expects that since the acquired assets would have some value, the net budget impact would be substantially less than $700 billion; similarly, net cash disbursements under the program would also be substantially less than $700 billion over time because, ultimately, the government would sell the acquired assets and thus generate income that would offset much of the initial expenditures.

In addition to any net gain or loss on the purchase of $700 billion or more in assets, the government also would incur administrative costs for the proposed program. Those costs would depend on the kinds of assets purchased or insured. On the basis of the costs incurred by private investment firms that acquire, manage, and sell similar assets, CBO expects that the administrative costs of operating the program could amount to a few billion dollars per year, as long as the government held all or most of the purchased assets.

Other provisions in the legislation would on net increase the budget deficit. For example, the legislation would allow the Federal Reserve to pay interest immediately on certain reserve balances of depository institutions, rather than starting on October 1, 2011, as allowed under current law. CBO estimates that, over the next three years, the provision would reduce the Federal Reserve’s payments of its profits to the Treasury, which are classified as revenue in the federal budget.

In addition, a number of provisions in the bill would affect federal revenues by changing tax law, including provisions that would limit the deductibility of executive compensation for certain firms selling assets; allow losses incurred by certain taxpayers on preferred stock in Fannie Mae and Freddie Mac to be treated as ordinary rather than capital losses; and exclude from income amounts attributable to the cancellation of mortgage debt of individuals in certain circumstances. The Joint Committee on Taxation estimates that, on net, these provisions would reduce federal revenues.

Enacting the legislation could also affect other federal spending—including, for example, outlays from the operations of Fannie Mae, Freddie Mac, federal housing programs, and deposit insurance. Some of those effects would be related to how TARP would be used to purchase assets (including what kinds of assets would be acquired and from what types of institutions), and how successful the program would be in restoring liquidity to the nation’s financial markets.

Intergovernmental and Private-Sector Mandates

The non-tax provisions of the bill would impose no intergovernmental or private-sector mandates as defined in the Unfunded Mandates Reform Act.

I hope this information is helpful to you. If you have further questions about CBO’s analysis, do not hesitate to contact me.

Sincerely,
Peter R. Orszag
Director

cc:

Honorable Spencer Bachus
Ranking Member

Honorable John M. Spratt Jr.
Chairman
Committee on the Budget

Honorable Paul Ryan
Ranking Member

Identical letter sent to the Honorable Christopher J. Dodd.

CBO has released a cost estimate for HR 7174, the James Zadroga 9/11 Health and Compensation Act of 2008.

The legislation would provide:

• Health care benefits for eligible emergency personnel who responded to the terrorist attacks in New York City on September 11, 2001, and for recovery and clean-up workers following the attacks;

• Health care benefits to eligible residents and others present in the part of New York City that was affected by those attacks; and

• Monetary compensation to newly eligible individuals for death and physical injury claims resulting from the attacks.

In addition, the legislation would raise revenues by altering various provisions of the tax code.

CBO estimates that enacting H.R. 7174 would increase direct spending by just under $11 billion over the 2009-2018 period. The Joint Committee on Taxation (JCT) estimates that the tax provisions in the bill would increase revenues by about $11 billion over the same period. On balance, CBO and JCT estimate that the direct spending and revenue effects from enacting the legislation would reduce deficits by about $230 million over the 2009-2013 period and by $35 million over the 2009-2018 period.

A Wall Street Journal blog posting mischaracterizes CBO’s testimony earlier this week on the net budget impact of the Treasury proposal to buy troubled assets. The Wall Street Journal blog states that the plan “likely won’t have any effect on the 2009 budget deficit.” That is incorrect.

Here’s what I said in the testimony:

“In particular, the federal budget would not record the gross cash outlays associated with purchases of troubled assets but, instead, would reflect the estimated net cost to the government of such purchases (broadly speaking, the purchase cost minus the expected value of any estimated future earnings from holding those assets and the proceeds from the eventual sale of them). In CBO’s view, that budgetary treatment best reflects the impact of the purchases of financial assets on the federal government’s underlying financial condition. The fundamental idea is that if the government buys a security at the going market price, it has exchanged cash for another asset rather than caused a deterioration in its underlying fiscal position.”

The testimony then noted that even though the gross cash outlays would perhaps amount to $700 billion, the net budget impact would be substantially smaller because the government would be acquiring assets with some value. It did not say, though, that the net budget impact would be zero, as the Wall Street Journal suggests.

So what will the net budget impact be, even if it’s substantially smaller than $700 billion? That depends on three factors: (a) the degree to which the transactions result in a gain or loss to the government; (b) the administrative costs of running the program; and (c) any interactive effects with other government programs. The first issue is central, and the testimony noted that “whether those transactions ultimately resulted in a gain or loss to the government would depend on the types of assets purchased, how they were acquired and managed, and when and under what terms they were sold.”

The testimony went on to explore the forces that could affect any gain or loss. “In addition to the future evolution of the housing prices, interest rates, and other fundamental drivers of asset values, two key forces would influence the net gain or loss on the assets purchased:

• Whether the federal government seeks and is able to succeed in obtaining a fair market price for the assets it purchases and, in particular, whether it can avoid being saddled with the worst credit risks without the purchase price reflecting those risks. Concerns about the government’s overpaying are particularly salient when sellers offer assets with varying underlying characteristics that are complicated to evaluate.  Such problems are attenuated the more that the government focuses on buying part of a given asset from institutions that all own a share of that asset, rather than buying different assets from different institutions. That is, the government is more likely to pay a fair price when multiple institutions are competing to sell identical assets than when it has to assess competing offers for different assets with hard-to-determine values.

• Whether, because of severe market turmoil, market prices are currently lower than the underlying value of the assets. If current prices reflect “fire sale” prices that can result from severe liquidity constraints and the impairment of credit flows, then taxpayers could possibly benefit along with the institutions selling the assets. Under normal circumstances, prices do not long depart from their fundamentals because the incentive to engage in arbitrage and profit from price discrepancies is large. But arbitrage practices work less well when liquidity is restrained, as it is now, and many potential arbitragers cannot get short-term financing. It is therefore at least possible that the prices of some assets are below their fundamental value; in that case, to the extent that the government bought now and held such assets until their market prices recovered to reflect that underlying value, net gains would be possible.”

Nothing in CBO’s testimony should be interpreted as suggesting that the interplay between these two forces would generate a net impact of zero for the transactions alone. Indeed, although the lack of specificity in the bill means that CBO cannot currently quantify its net budgetary impact, and although there is some possibility that the government could realize a net gain on the transactions authorized under the bill, it seems more likely that enacting the bill would result in an increase in the federal deficit. In other words, the net budgetary cost (including administrative costs) is very likely to be substantially smaller than $700 billion, but it seems likely to be greater than zero.

An article in today’s Washington Post suggests that in testimony yesterday, I argued that the proposed Troubled Asset Relief Act of 2008 “could actually worsen the financial crisis” by forcing institutions to recognize new losses on their balance sheets through the sale of assets to the government and by revealing some of those same institutions to be insolvent. This is not fully accurate, and some clarification is in order.

First, a technical point: A company holding an overvalued asset would have to write down the value of that asset not only if it actually sold that asset to the government at a price beneath its current book value, but also if other companies sold comparable assets to the government at a price beneath that book value. This is the essence of mark-to-market accounting. (For example, suppose Company A owns Asset X, which it holds on its books at a value of $100. Now suppose that Company B holds an asset comparable to Asset X, which it sells to the government for $50. As a result, Company A must mark down the value of Asset X to $50, because a comparable market transaction has revealed its value. In the absence of the proposed program, that comparable market transaction may not exist because of illiquidity in financial markets.) Establishing clearer market prices for currently illiquid assets could trigger similar asset write-downs and thus reveal additional institutions to be insolvent.

The second and more important point, though, is that even if this process revealed more financial institutions to be insolvent, the result would not necessarily worsen the financial crisis. As I stated in my testimony yesterday before the House Budget Committee, the current crisis is fundamentally one of collapsing confidence in the financial markets and “providing more transparency about the lack of solvency at specific institutions may be necessary to restore trust in the financial system.” In other words, to restore confidence, participants in the financial markets need more clarity about which institutions are solvent and which are not. To the extent proposals like the Treasury one can accomplish this end, it would be a step toward resolving the crisis, not worsening it.

Finally, it seems worth emphasizing again a key point from yesterday’s testimony — that the financial markets face two distinct, but related, problems. One problem is that the markets for some types of assets and transactions have essentially stopped functioning. To address that problem, the government could conceivably intervene as a “market maker,” by offering to purchase assets through a competitive process and thereby provide a price signal to other market participants. That type of intervention, if designed carefully to keep the government from overpaying, might not involve any significant subsidy from the government to financial institutions. The second problem involves the potential insolvency of specific financial institutions. Restoring solvency to insolvent institutions requires additional capital injections, and one possible source of such capital is the federal government. Although the problems of illiquidity and insolvency are interrelated, they are at least conceptually distinct. Indeed, some policy proposals appear to be aimed primarily at the illiquidity of particular asset markets, and others appear to be aimed primarily at the potential insolvency of specific financial institutions. The Treasury proposal appears to be motivated primarily by concerns about illiquid markets. The more the government overpays for assets purchased under that act, however, the more the proposed program would instead provide a subsidy to specific financial institutions, in a manner that seems unlikely to be an efficient approach to addressing concerns about insolvency.

This morning I am testifying before the House Budget Committee on the federal response to market turmoil. (Click here to link to today’s testimony). The text of my written statement is copied below:

Chairman Spratt, Ranking Member Ryan, and Members of the Committee, thank you for inviting me to testify this morning on the budgetary and economic implications of the recent turmoil in financial markets and the Administration’s proposal to address it.

Since August 2007, the Federal Reserve and the Treasury have been attempting to address a series of severe breakdowns in financial markets that emanated from the bursting of the housing bubble, leading to substantial losses on mortgage-related securities and great difficulty in accurately ascertaining the financial condition of the institutions holding such securities. Those problems generated significant increases in risk spreads (or the interest rates charged on risky assets relative to Treasury securities) but, more important, contributed to a broader collapse of confidence, with the result that financial institutions became increasingly unwilling to lend to one another.

Over the past several weeks, the collapse of confidence in financial markets has become particularly severe. Short-term loans between financial institutions have fallen off sharply. Instead, the Treasury and the Federal Reserve have become the financial intermediaries for them. In other words, rather than financial institutions with excess money lending to institutions needing short-term funding, many institutions with excess short-term money have purchased Treasury securities, the Treasury has placed the proceeds on deposit at the Federal Reserve, and the Federal Reserve has then lent the money out to those institutions needing short-run funding.

Thus far, turmoil in the financial markets has had less impact on macroeconomic activity than may have been expected, and, indeed, economic growth was relatively strong in the second quarter of this year—in part because of the stimulus package enacted earlier this year. A modern economy like the United States’, however, depends crucially on the functioning of its financial markets to allocate capital, and history suggests that the real economy typically slows some time after a downturn in financial markets. Moreover, ominous signs about credit difficulties are accumulating. The issuance of corporate debt plummeted in the third quarter, and the short-term commercial paper market has also been hit hard. Bank lending, which has thus far remained relatively strong, will undoubtedly be severely curtailed by the difficulties that banks are facing in raising capital. Such a curtailment of credit means that businesses and individuals will find it increasingly difficult to borrow money to carry out their normal activities. In sum, the problems occurring in financial markets raise the possibility of a severe credit crunch, which could have devastating effects on the U.S. and world economies.

To mitigate the risks, the Department of the Treasury has proposed the Troubled Asset Relief Act of 2008, and similar proposals have also been put forward by the Chairman of the House Financial Services Committee and the Chairman of the Senate Banking Committee. In an analysis of these proposals, it is useful to identify two problems facing financial markets: illiquidity triggered by market panic and the potential insolvency of many financial institutions.

One problem is that the markets for some types of assets and transactions have essentially stopped functioning. To address that problem, the government could conceivably intervene as a “market maker,” by offering to purchase assets through a competitive process and thereby provide a price signal to other market participants. (That type of intervention, if designed carefully to keep the government from overpaying, might not involve any significant subsidy from the government to financial institutions.) The second problem, though, involves the potential insolvency of specific financial institutions. By some estimates, global commercial banks and investment banks may need to raise a minimum of roughly $150 billion more to cover their losses. As of mid-September 2008, cumulative recognized losses stood at about $520 billion, while the institutions had raised $370 billion of additional capital.  Restoring solvency to insolvent institutions requires additional capital injections, and one possible source of such capital is the federal government.

Those two problems are related in the sense that it is difficult to know which institutions are insolvent without being able to value the assets they hold (which in turn is impeded by illiquid markets). Undisclosed losses are unlikely to be distributed uniformly throughout the financial system, and the inability to identify which institutions are carrying the largest losses has led to a breakdown of trust in the entire financial sector.  That loss of trust has sharply increased the cost of raising capital and rolling over debt, which threatens the solvency of all financial institutions. Injecting more capital into financial institutions could help to restore liquidity to some financial markets, because, with larger cushions of capital to protect against default, the institutions would be more willing to lend to one another. Another linkage between these two problems could occur if some institutions are unwilling to sell assets at current market prices if that then triggered the recognition of accounting losses; such reluctance to sell can contribute to illiquid markets. With additional equity, those institutions may be more willing to sell at current market prices even if that required recognizing losses.

Although the problems of illiquidity and insolvency are interrelated, they are at least conceptually distinct. Indeed, some policy proposals appear to be aimed primarily at the illiquidity of particular asset markets, and others appear to be aimed primarily at the potential insolvency of specific financial institutions.

Most of this testimony examines the Troubled Asset Relief Act of 2008. That act appears to be motivated primarily by concerns about illiquid markets. The more the government overpays for assets purchased under that act, however, the more the proposed program would instead provide a subsidy to specific financial institutions, in a manner that seems unlikely to be an efficient approach to addressing concerns about insolvency.

The Troubled Asset Relief Act of 2008
The Congressional Budget Office (CBO) has reviewed the Troubled Asset Relief Act of 2008, as proposed by the Administration. The act would authorize the Secretary of the Treasury to purchase, hold, and sell a wide variety of financial instruments, particularly those that are based on or related to residential or commercial mortgages issued prior to September 17, 2008. The authority to enter into agreements to purchase such financial instruments, which the proposal refers to as troubled assets, would expire two years after its enactment.

The legislation would appropriate such sums as are necessary, for as many years as necessary, to enable the Secretary to purchase up to $700 billion of troubled assets at any point during the two-year window of opportunity (though cumulative gross purchases may exceed $700 billion as previously purchased assets are sold) and to cover all administrative expenses of purchasing, holding, and selling those assets. The federal debt limit would be increased by $700 billion.

At this time, given the lack of specificity regarding how the program would be implemented and even what asset classes would be purchased, CBO cannot provide a meaningful estimate of the ultimate net cost of the Administration’s proposal. The Secretary would have the authority to purchase virtually any asset, at any price, and sell it at any future date; the lack of specificity regarding how that authority would be implemented makes it impossible at this point to provide a quantitative analysis of the net cost to the federal government.

The Budgetary Treatment of the Proposal
The federal cost of the proposal could be reflected in the budget either on a cash basis or on a net-expected-cost basis. The proposal would require that the federal budget display the costs of this new activity under the latter approach, using procedures similar to those contained in the Federal Credit Reform Act (but adjusting for market risk in a manner not reflected in that law). In particular, the federal budget would not record the gross cash outlays associated with purchases of troubled assets but, instead, would reflect the estimated net cost to the government of such purchases (broadly speaking, the purchase cost minus the expected value of any estimated future earnings from holding those assets and the proceeds from the eventual sale of them). That approach would be similar to the current budgetary treatment of a broad array of loans and loan guarantees made by the federal government, wherein the best measure of the cost to the government reflects not only initial disbursements but also the resulting cash flows in future years.

In CBO’s view, that budgetary treatment best reflects the impact of the purchases of financial assets on the federal government’s underlying financial condition. The fundamental idea is that if the government buys a security at the going market price, it has exchanged cash for another asset rather than caused a deterioration in its underlying fiscal position.

CBO expects that the Treasury would probably fully use its $700 billion authority in fiscal year 2009 to purchase various troubled assets. To finance those purchases, the Treasury would have to sell debt to the public. Federal debt held by the public would therefore initially rise by about $700 billion. Nevertheless, CBO expects that, over time, the net cash disbursements under the program would be substantially less than $700 billion, because, ultimately, the government would sell the acquired assets and thus generate income that would offset at least much of the initial cost.

Whether those transactions ultimately resulted in a gain or loss to the government would depend on the types of assets purchased, how they were acquired and managed, and when and under what terms they were sold. In addition to the future evolution of the housing prices, interest rates, and other fundamental drivers of asset values, two key forces would influence the net gain or loss on the assets purchased:

• Whether the federal government seeks and is able to succeed in obtaining a fair market price for the assets it purchases and, in particular, whether it can avoid being saddled with the worst credit risks without the purchase price reflecting those risks. Concerns about the government’s overpaying are particularly salient when sellers offer assets with varying underlying characteristics that are complicated to evaluate. As discussed further below, such problems are attenuated the more that the government focuses on buying part of a given asset from institutions that all own a share of that asset, rather than buying different assets from different institutions. That is, the government is more likely to pay a fair price when multiple institutions are competing to sell identical assets than when it has to assess competing offers for different assets with hard-to-determine values.
• Whether, because of severe market turmoil, market prices are currently lower than the underlying value of the assets. If current prices reflect “fire sale” prices that can result from severe liquidity constraints and the impairment of credit flows, then taxpayers could possibly benefit along with the institutions selling the assets. Under normal circumstances, prices do not long depart from their fundamentals because the incentive to engage in arbitrage and profit from price discrepancies is large. But arbitrage practices work less well when liquidity is restrained, as it is now, and many potential arbitragers cannot get short-term financing.  It is therefore at least possible that the prices of some assets are below their fundamental value; in that case, to the extent that the government bought now and held such assets until their market prices recovered to reflect that underlying value, net gains would be possible.

In addition to any net gain or loss on the purchase of $700 billion or more in assets, the government would also incur significant administrative costs for the proposed program. Those costs would depend on what kinds of assets were purchased. On the basis of the costs incurred by private investment firms that acquire, manage, and sell similar assets, CBO expects that the administrative costs of operating the program could amount to a few billion dollars per year, as long as the government held all or most of the purchased assets

The proposed program could affect other federal programs—including, for example, the operations of Fannie Mae, Freddie Mac, federal housing programs, and deposit insurance. The program’s impact on the future costs of other federal programs would depend on what kinds of assets were acquired and from what types of institutions and on how successful the program was in restoring liquidity to the nation’s financial markets.

Determining a Purchase Price for Troubled Assets
The legislation would authorize the Secretary to purchase almost any conceivable type of asset related to residential or commercial mortgages, from individual loans to complex insurance products, and possibly other assets not directly related to such mortgages. The Treasury Department has indicated that it would conduct reverse auctions for at least some of the purchases. In a reverse auction, many potential sellers would bid on the price to be accepted by the government, and the lowest bidders would win. Using a reverse auction process in which multiple sellers compete to offer the Treasury the lowest price for a set volume of similar troubled assets would help ensure that the government was paying a fair price for those assets.

In the context of financial assets, a reverse auction works best when (1) different sellers are offering to sell their shares in the same asset rather than offering to sell different assets and (2) when many sellers participate. When sellers are offering different assets, the lowest bidder may win by offering an asset with particularly risky or poor future prospects, and the price may not reflect the degree to which that specific asset is risky or impaired. Consequently, the federal government could purchase too many risky or impaired assets without enjoying sufficient price discounts. Similarly, if the number of participants in the reverse auction is unduly limited (either because few institutions own the asset that the government wants to purchase or because few owners choose to participate in the auction), the government could overpay relative to a fair price.

One focus of the Treasury program seems likely to be mortgage-backed securities (MBSs), which are ownership shares in large pools of individual mortgages. Financial institutions own hundreds of thousands of such securities, reflecting more than $7 trillion in pooled mortgage assets; most of the hard-to-value MBS assets are likely to be in the nearly $3 trillion not owned or insured by Fannie Mae and Freddie Mac. The Treasury Department has indicated that the reverse auctions for MBS assets might be conducted security by security—that is, there would be a separate “mini-auction” for each tranche of the MBSs.  If those tranches were widely distributed across financial institutions and if the government offered to purchase only a small share of each tranche, the result should be that the government would obtain a fair price for such purchases.

Reverse auctions may not obtain a fair price for the government for many other types of assets the Treasury may seek to purchase. In particular, determining fair market prices using an auction is difficult for assets that are not clearly the same or very similar in quality—that is, when the seller has more information about the quality of the asset than the buyer does. In such cases, each auction participant will offer up assets with unique attributes known only to the seller, thus increasing the likelihood that the government will pay too much. That type of problem is likely to be particularly severe for assets like individual home mortgages or esoteric derivative products entirely owned by specific financial institutions.  Substantial purchases of such assets would make it unlikely that the Treasury could operate the proposed new program at little or no net cost.

In other words, the more that the Treasury program concentrates on assets that are difficult for a buyer to value, the more likely that the government will overpay. The more that occurs, the more the program moves beyond simply reestablishing trading in illiquid financial markets and instead subsidizes the particular financial institutions selling assets to the government, at a cost to taxpayers.

Financial Market and Other Effects of the Proposal
The Treasury’s proposal is aimed at stabilizing financial markets and the economy by providing liquidity to support credit flows. One reason that credit markets have seized up is the uncertainty about who holds impaired assets and what they are worth, especially those related to mortgages. The underlying losses on those assets reflect the decline in home prices, but the mortgage loans have been repackaged as MBSs and then again into more complex securities such as collateralized debt obligations and credit default swaps that have spread the risk across many financial markets.

The proposal would allow the Treasury to buy up those assets regardless of the form in which they are held. The core problem, though, has moved beyond the mortgage markets and has become a broader collapse of confidence in financial markets. It therefore remains uncertain whether the program will be sufficient to restore trust, especially if the program is limited to the asset classes in which the government is least likely to overpay for its purchases.

At the same time, intervention on a massive scale is not without risks to taxpayers and to the economy.  Almost by definition, the intervention cannot solve insolvency problems without shifting costs to the taxpayers. Ironically, the intervention could even trigger additional failures of large institutions, because some institutions may be carrying troubled assets on their books at inflated values. Establishing clearer prices might reveal those institutions to be insolvent. (To the extent such insolvencies were revealed, the net effect might not be deleterious. Providing more transparency about the lack of solvency at specific institutions may be necessary to restore trust in the financial system.)

More broadly, there is an inherent tension between minimizing the costs to taxpayers and pursuing other policy goals. For example, as the manager of troubled mortgage assets, the government would be likely to come under intense pressure to avoid foreclosures or to take other steps to pursue goals for low- and moderate-income housing through activities that would not be subject to the constraints of the normal budget process. Those objectives may benefit specific homeowners, at the expense of taxpayers as a whole.

Alternatives to the Treasury’s Proposal
Some analysts, in assessing the Treasury’s proposal, have pointed out that other recent actions by the Federal Reserve and the Treasury have given taxpayers significantly more upside in the form of equity stakes in the companies that receive assistance. Those actions have been aimed at supporting particular troubled institutions, rather than at enhancing the liquidity of the financial markets. Under some alternative proposals, the government would receive shares in an institution if it ultimately lost money on the sale of assets purchased from the institution. That approach would reduce the risk of overpaying for securities if the seller had more information about the value of those securities than the Treasury did. However, institutions that gave up equity would presumably expect to receive higher prices for their assets, and an equity stake in the firms might not offer any better upside to taxpayers than direct purchases of the assets on a risk-adjusted basis. Furthermore, healthy institutions might be deterred from participating, which could make it more likely that the federal government would overpay for assets by limiting the potential number of sellers—and the potential dilution for existing shareholders if asset prices declined in the future might make it challenging for financial institutions that issued such equity to the government to raise private capital in the future.

An alternative approach that is more directly aimed at addressing insolvency concerns is for the government to invest directly in financial institutions to strengthen their capital positions, without directly purchasing troubled assets. The injections could take the form of preferred stock, which would effectively lower the cost of new capital for the institutions. Such proposals could be modeled along the lines of the Reconstruction Finance Corporation, a Depression-era institution.

A number of twists to that approach have been offered. Some versions require that the institutions match the injection with new private funds in the form of common stock. In addition, some require that the underwriting risk associated with raising new capital be mutualized by the group of participating institutions acting as a syndicate. The syndicate would be responsible for at least half of the underwriting burden, which would give it an incentive to limit membership to solvent institutions only. Participating banks might also be required to suspend dividends, which would increase their retained earnings and thus add directly to capital. (Although institutions can always cut their dividends, doing so usually sends a bad signal to financial markets. A requirement could dilute the effect of that bad signal.)

Such proposals have some advantages:

• They provide some upside to taxpayers in the form of dividends and capital gains on preferred stock. Under some proposals, the payments of dividends to the government would be deferred.
• They avoid the challenge of pricing and then selling individual assets (although they raise the issue of how to price the equity shares the government offers to purchase).
• They avoid rewarding the firms that have made the worst investment decisions.
• They keep the government as a minority shareholder. The firms’ managers would continue to run the firms on a profit-maximizing basis, thereby mitigating the risks of the government using its equity positions to pursue a range of public policy goals.
• They could impose losses on shareholders and changes in management.
• Such plans have some disadvantages though:
• They fail to address directly the illiquidity problems for some assets and the associated uncertainty.
• The assistance may not be targeted to the institutions most in need of help, and the firms that most need capital may be most reluctant to take it.
• The approach could inject additional funds into institutions whose business model is no longer viable. Past experience suggests that extending the operations of insolvent institutions may increase the ultimate cost to taxpayers.
• The proposals raise difficult questions about eligibility criteria. For example, would finance companies that are part of large diversified holding companies be eligible?