Congressional Budget Office
Director's Blog

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?

This morning I’m testifying on climate change before the Committee on Ways and Means in the House of Representatives.

Global climate change is one of the nation’s most significant long-term policy challenges. Reducing greenhouse-gas emissions would be beneficial in limiting the risks associated with climate change, especially the risk of potentially catastrophic damage. Reducing those emissions, however, would also impose costs on the economy.  Our political system arguably has difficulty addressing this type of issue, in which there are short-term costs required in order to reap expected long-term benefits.

As I’ve discussed in other recent testimonies (see here and here), policymakers designing a cap-and-trade program for greenhouse gas emissions face important decisions about how to allocate allowances: whether to sell or give them away, and if they are sold, how to use the revenue generated. In addition, policymakers would face decisions about the degree of flexibility offered to firms — especially the flexibility to reduce emissions in those years in which it is least expensive to do so.  These decisions can have substantial effects on the costs of meeting any given climate target.

Today’s testimony also includes a discussion of additional complexities that arise for energy-intensive U.S. industries facing foreign competition (the steel and aluminum industries, for example). Under stringent cap-and-trade policies, these industries would face increased import competition (and export competition in third countries) from countries with less stringent policies on greenhouse gas emissions, which could not only reduce domestic production in those industries but also undermine part of the environmental benefit from an emissions reduction scheme. In my testimony, I examine a few recent proposals intended to mitigate these concerns.

I spoke today at the 10th anniversary of the Center for Health Policy (CHP) and the Center for Primary Care and Outcomes Research (PCOR) at Stanford University.  The webcast of the lecture is available here. (Here are the slides from the talk.)  My remarks touched upon a theme that I will be discussing in more detail in other lectures later this fall: that just as the field of economics suffered because it mostly ignored psychology for too long, so too much of medical science and health policy has been largely ignoring the crucial role of expectations, beliefs, and norms.  Perhaps the most compelling example involves the placebo effect, which tends to be dismissed as a statistical annoyance rather than examined in and of itself as a powerful force — often more potent empirically than the ‘medical’ intervention formally being studied.

As a follow-up to my previous post on CBO’s estimate of the subsidy cost for extending government loans to automobile firms, I thought it might be useful to highlight the deferment feature of the authorized program, which has a significant effect on the estimated subsidy. In particular, under the program, borrowers could defer payments of principal and interest for up to five years after putting into operation the new or modified plant funded by the loan. CBO assumes that most borrowers would take advantage of the deferment option, and our subsidy estimate reflects the resulting cost to the federal government—taking into account the time-value of money—of delaying loan repayments. CBO estimates that the option to defer payments for five years accounts for about half of our current estimate of subsidy costs.

The emergence of H5N1, or “avian flu,” motivated the Department of Health and Human Services’ 2005 plan to prepare for and combat an influenza pandemic. Three years ago domestic manufacturers were unable to rapidly produce enough vaccine to protect the more than 300 million people living in the United States. That remains the case today. With current technology, a pandemic could circle the globe more quickly than vaccines could be produced.

HHS’s plan has enlarged the role of the federal government in the influenza vaccine market, and the paper released by CBO today examines that increasingly prominent role — in developing new vaccines, expanding the capacity of the industry to manufacture them, and procuring stockpiles of prepandemic vaccines.

HHS’s plan has multiple objectives, including to:

• Increase manufacturing capacity by refurbishing and expanding plants that produce vaccines using traditional egg-based processes (developed in the 1940s) and increasing more costly cell-based manufacturing technology.
• Make vaccines available more quickly. The plan takes two approaches to this objective. First, stockpile a relatively small amount of prepandemic vaccines that could blunt the worst effects of a pandemic by protecting particularly vulnerable groups and first responders. Second, develop so-called next-generation vaccines that can be produced more rapidly than currently available vaccines to more efficiently  meet long term needs.

Ongoing research has changed the environment in which HHS’s plan was originally formulated in at least one important regard. Adjuvants—substances that may be added to influenza vaccines to reduce the amount of active ingredient (called antigen) needed per dose of vaccine—are showing promise in clinical trials in the United States; some of them have been approved for limited uses in Europe. That promise may offer a basis on which to make adjustments to HHS’s plan.

 Specifically, CBO reached the following conclusions:

• The manufacturers of currently approved vaccines made in the United States cannot produce vaccines of sufficient effectiveness, in sufficient quantities, or in the time required to meet public health needs in the event of an influenza pandemic.
• In the short term, adjuvanted vaccines offer the best hope for achieving HHS’s goal of having enough vaccine to protect 300 million people within six months of the outbreak of an influenza pandemic.
• CBO estimates that it would cost between $1.2 billion and $1.8 billion to build new facilities for producing adjuvanted cell-based vaccines and between $7.6 billion and $11.4 billion to build new production facilities for cell-based vaccines without adjuvants.
• Manufacturing capacity needed to produce pandemic-influenza vaccine exceeds that necessary to make seasonal vaccine; ongoing federal support may be required to meet and maintain necessary capacity.

Adjuvants developed since 2005 could substantially reduce the amount of antigen needed per dose, raising the question about whether HHS’s current policy is the most cost-effective approach to meeting its vaccine production goals. In light of this, the report briefly examines several other options to consider if adjuvanted vaccines prove successful, including reducing capacity targeted for manufacturing cell-based influenza vaccines while expanding resources available to support development of next-generation vaccines, entering into advance supply agreements (an approach used by several European nations that allows countries to make advance payments to manufacturers in exchange for a guaranteed supply of vaccine in the event of a pandemic); and modifying the size of the planned vaccine stockpile.
 

Last year, the Congress authorized the Department of Energy to make $25 billion in loans to auto manufacturing firms and suppliers of automotive components. Manufacturers could use those loans to reequip or establish facilities to produce “advanced technology vehicles” that would meet certain emissions and fuel economy standards; component suppliers could borrow funds to retool or build facilities to produce parts for such vehicles.

Subsequent funding was required before such loans could be made, and that funding has not yet been provided.  The budgetary cost for such loans, based on the rules in the Federal Credit Reform Act of 1990, reflects the expected cost to the government of any subsidy, not the face value of the loans.

Several recent press reports have incorrectly suggested that CBO has estimated a 15 percent subsidy cost for loans to the automakers, so that $25 billion in loans would cost $3.75 billion.  CBO’s analysis, however, suggests a 30 percent subsidy cost for such loans under the conditions specified in the authorizing legislation.  The resulting subsidy cost would imply a budget cost of $7.5 billion for $25 billion in loans.  (Early this year, CBO had informally suggested a 15 percent subsidy cost.   Since then, however, credit conditions for the auto manufacturers have deteriorated markedly — the market interest rates on their outstanding debt, for example, have risen dramatically.)