The US Congress has thrown out the bailout proposal from treasury secretary Henry Paulson and the markets have crashed. What prompted US congressmen to reject the bailout, even at the cost of more market losses and increased risks of a deep recession? By Vivek Sharma

It takes lots of chutzpah to go before the most powerful parliament in the world and ask for blanket powers to spend $700 billion of tax payer money, at the sole discretion of a bunch of government officials and with little regulatory oversight.

US treasury secretary Henry Paulson, former Wall Street CEO, has lots of it. He was so confident about his bailout plan that he hardly bothered about the details of the plan and how it would be implemented. His original proposal document before the US Congress was just three pages!

Probably he was betting that, with the support of US Fed chairman Ben Bernanke, he could scare congressmen enough about the gravity of the crisis and get their immediate approval. So both men presented their doomsday scenarios before the Congress, but the lack of details made congressmen sceptical. Politics of the US presidential elections pulled the bailout plan in different directions. Henry Paulson tried to charm the Congress, even going on one knee before Speaker Nancy Pelosi.

In the end, they came up with a deal, but only after the US Congress added a bunch of provisions to protect themselves and stretched the proposal to nearly 200 pages.

But, almost completely unexpectedly, the US Congress voted against the plan by a narrow margin. Markets collapsed, with the Dow Jones index recording the biggest ever fall in a day on points. The US government and the Fed are now left with ad hoc measures to fight the financial crisis, which seems to be worsening by the day.

The root cause of the financial crisis, as everyone knows by now, is the huge amount of credit derivative securities held by banks - not just in the US, but in most developed markets. As the underlying assets, mostly retail mortgage loans, of these securities deteriorated, banks had to write down the value of their holdings. As per current accounting rules, the values of such securities have to be marked to current market prices. The market for credit derivatives is relatively illiquid and they are difficult to value because of their complex structure. When the market turns sour, prices can fall sharply and every firm which holds such assets is forced to write down the value of their investments.

Financial crises of the past were limited to select banks which were saddled with bad loans and there were always some pockets of safety in the system, which in turn formed the base for the eventual recovery. But now, there is hardly any bank left untouched by the turmoil as every banker had invested heavily in credit derivatives. The whole idea of securitisation was about spreading the risks across a large number of investors and thereby reducing the possibility of any one of them going belly up.

But, when the asset pools became too big, every bank had a share that was large enough to bring it down if the asset values dropped.

Asset write-downs erode the capital base of banks and they become unable to extend credit. When this happens across the system, as it is now, businesses are starved of credit. If credit flows freeze, it can be disastrous for the economy especially when overall growth is anaemic. Since the current crisis is truly global, and since the global economy is slowing down, the risk of a serious global recession is very real.

The Troubled Assets Relief Programme, or TARP, proposed by Paulson sought to address the problem through a government purchase of all kinds of troubled securities from banks. Once the banks get rid of such risky assets, they will resume lending and the economy may escape a deep recession. The US government was to hold these securities and, hopefully, dispose them off when the markets improve some time in the future.

The primary concern about the Paulson plan was that it was very vague on the price the US government would pay for the troubled assets. If the price were to be too low, not many banks would participate and the plan would fail. So, the government would have to offer a better price than the current market prices.

Fed chairman Bernanke confirmed in his testimony to the US Congress that, if the plan were to work, the price offered would have to be closer to what investors would get if the securities were held to maturity. That would be well above the current market price and exposes the government to significant risks, especially if there were to be more defaults in the underlying mortgage loans.

Paulson had proposed a 'reverse auction' to buy up such securities, where banks submit their offers and the lowest bid is accepted. The trouble with this method is that banks have a better idea of the quality of these assets than the government and it would be in the interest of the banks to quote higher prices. It is also possible that banks would not have been interested in actually dumping all the troubled assets. All they would have had to do was ensure that the US government buys just enough credit derivatives at an inflated price, which then becomes the market price.

Then, all the banks can mark up the credit derivates in their books to the 'new and improved' market price. If some bank desperate for cash quotes a very low price, every other bank would be in trouble, as the low price becomes the new market rate and the asset values would have to be written down further. That would aggravate the crisis.

Probably the major reason why there were not enough backers in the US Congress for the Paulson plan was that it was based on a very risky premise. Under the plan, the US treasury sought to become the biggest ever vulture fund. Distressed asset funds, similar to the asset reconstruction companies in India, buy up troubled assets at fire sale prices in the hope of selling them for a profit in future. Their viability depends entirely on the ability to judge the market bottom for asset prices and then strike deals at those levels. If they misjudge the bottom and buy too early, they land in trouble.

The Paulson plan was based on the assumption that credit derivatives are heavily undervalued in the books of banks. There is a crisis, everyone has panicked, and it is quite possible that market prices of those assets are below their intrinsic value, whatever that is. There are market players like Bill Gross, CEO of the world's biggest bond fund manager, who believe that credit derivatives are worth no less then two-thirds their face value. That is way above just about one-fifth of the face value which Merrill Lynch got when it unloaded some of the investments recently. If that is indeed the case, the US government would have made a fat profit from the Paulson plan.

The risk is that there is no sure way to tell if the credit derivatives are really undervalued. US Fed chairman Bernanke quipped nearly a year back that he would like to know 'what these damn things are worth. Even now, it is unlikely that Bernanke, or anyone else for that matter, has a better sense of the intrinsic value of these securities.

As per the detailed proposal before the US Congress, the treasury secretary was supposed to come up with details of how the assets would be priced and a system for purchases. It was quite possible that the pricing and the purchase procedures would have been decided by the same experts from Wall Street, hired by the treasury secretary to work for the bailout board. Nobody else understands these securities, so the Paulson Plan would have been reduced to a scheme structured by some bankers for the benefit of other bankers.

Many of the proposals inserted under pressure from US Congress into the original Paulson Plan were vague and would have anyway proved ineffective. One such provision required the treasury secretary to demand equity warrants or senior debt at remunerative interest rates from the firms participating in the bailout. This was intended to punish existing shareholders and creditors in such firms by bringing down the value of their holdings and to provide an upside potential to the government in the future.

However, for this provision to be effective, the government would also have to take a significantly high stake like it did in the AIG bailout. Only firms on the brink of collapse, which have no other options, would agree to cede majority stakes. So, under the Paulson Plan, the US government would have had to settle for minor stakes in most cases.

Other insertions like the limits on executive compensation in firms accepting the bailout merely pandered to political considerations and would not have made much difference. This provision would have actually made it difficult for banks to attract and retain talent.

To protect themselves from blame, US congressmen added a provision which required the US president to recoup any losses on account of the bailout programme from the financial services industry after a period of five years. So, if there were losses because of the bailouts and the market did not stabilise, this provision would have imposed higher taxes or some other levies on banks and delayed their recovery for many more years. In that sense, the bailout appeared not intended to prevent bankruptcies but only to delay them.

After seeing all these, it is not very surprising that a majority of the US Congressmen were not comfortable enough to give such extraordinary powers to treasury secretary Paulson. That too for a plan which none could guarantee would end the current crisis.

Not many can better politicians in sensing and then hedging risks to their careers. Yesterday, members of the US Congress were doing just that. Saving the world can wait!