With the historic changes in the nation’s financial systems these past several weeks, those of us interested in the nation’s sustained fiscal health wonder what to think.  Given the near collapse of the credit markets last week, President Bush offered a huge bailout program to restore systematic liquidity by socializing “illiquid” assets”.  The concept supporting this plan is one that holds these assets have value but cannot be traded because of temporary market conditions.   Presumably, when the conditions improve, the markets will again recognize the intrinsic value of the assets and the government will be able to sell them for their real value.  In that way, the government will eventually recover the money it’s invested in the bailout.

We know very little about the details of the plan and that uncertainty is one of the reasons the markets are so volatile. Financial theorists tell us that risk is defined as the uncertainty of return and without a clear definition of what the government will eventually do, traders are uncertain as to what the future holds.  They don’t know if the bailout will come to pass or if it will help them.  This quandary tends to further depress the price of assets as they are, by the uncertainty definition, more risky.

Right now, everyone who has an interest in the bailout has some notion of what the program should do.  They all operate with their preconceptions of what the bailout should include but, as the program becomes less murky, these same traders will begin to assess the efficacy of the bailout.  They will adjust their trading to be in concert with their expectations for the future prices of their assets.  This process was clearly demonstrated over the last three trading days; when the bailout was announced, optimism reigned and the markets exploded last Thursday and Friday.  When it became clear the politicians would extract a price, the optimism came out of the market to the tune of 370 points on the Dow Jones average.

The first specific question one might have is what the size of the bailout should be.  The $700 billion is clearly too low, if the program is not strictly defined.  The politicians have begun to agitate for a broader program—one that includes much more than loans secured by mortgages.  Conceivably, this could include credit card debts and car loans.  If these classifications are included, the bailout’s  cost estimate is way too low.

Assuming that the program is limited to real estate loans, we need to know what assets are actually impaired.  Word that half the mortgages Fannie and Freddie were buying what could be described as “sub-prime” does not mean that they are non-performing but they are suspect.  We do not know—but suspect—that the GSEs were the primary source of the illiquid assets.  The new owners of these assets must tell us which ones are not paying and which ones are.  Should the program acquire only assets that are now non-performing or should the program include assets that may become non-performing? The answer might make a huge difference in the size of the bailout.  Our leaders owe us an answer.

Posted by Ralf Seiffe….More later