Last time I blogged about why credit matters to the economy, today I will try and explain in as simple terms as possible what Paulson's original idea is all about.
The background is now familiar. Investment banks and securities firms, eager to provide outlets for a huge pile of global money, started bundling together more and more suspect mortgages, sliced them up and created Mortgage Backed Securities (MBS) (see my old posts on the credit crisis). The huge demand for these securities caused even more suspect mortgage lending. This all fueled the housing bubble which finally popped. When the value of houses started crashing the performance of the MBS tanked. They tanked so badly that it soon become apparent that no one could really figure out how to value them. When that happened, the market for these securities basically disappeared. [It is worth noting that though MBS are not the only culprit, they are the main one] Suddenly a major part of the asset side of these banks (both investment and commercial - the difference is not that significant anymore) balance sheets lost all of their value both because of the drop in housing values on which they are based, but also because of they worry about valuing them appropriately made no one interested in buying them. Banks suddenly faced a solvency crisis and needed to raise liquidity. Normally you can do this by selling assets but as I just explained, there is no market for them. Alternatively you can borrow money and lend it out or invest it to try and raise new capital through profits, but now no banks want to lend to each other because they are all worried about default (and rightly so, look at Lehman Brothers, WaMu, etc.) So with banks facing insolvency and the usual channels to overcome this blocked we find ourselves teetering on the brink of total meltdown in the banking sector.
What the Treasury proposes to do is to try and address the second part of the asset pricing problem for the MBS. Namely, that no one wants to buy them because no one can figure out what they are worth (and their worth depends in large part on the future performance of the housing sector). The Treasury claims that they are not worthless (as the current market price suggests) but that 'hysteria' [my word] in the credit market is causing the current price to be much too low. Basically this is a problem of asymmetric information (not knowing the true worth) and coordination failure (not knowing what will happen to housing values which depends on the freeing of credit, which, in turn, depends on confidence returning to the banking sector). Treasury thinks that it can figure out the true worth of these MBS assets and pay that today. Doing so, they believe, will calm the hysteria and free up credit because essentially banks will take the Treasury money and put it right back into T-Bills which will shore up the balance sheet, return them to solvency and make the eligible to borrow and lend again -- which will eventually trickle down to the housing market. Once the hysteria is gone and housing markets have stabilized, the true value of the MBS will become clear and the Treasury can start selling them back - hopefully for as much or even more than they paid.
You can see the risk: if the hysteria about the MBS does not calm down (no one wants to touch them ever again) or if the injection of liquidity does not free up enough credit to turn the housing market around, the Treasury could be stuck with a huge amount of worthless MBS and will end up loosing $700 billion with nothing to show for it. This is why some economists claim is it better to buy equity in the banks because then if it doesn't work you at least have some tangible assets you can sell (like, e.g., WaMu's retail branches that apparently Chase coveted). [The rejoinder to this is that the government may find itself heavily invested in banking, will have a huge amount of complicated real and paper assets to deal with, and will go to even greater lengths to prevent failure.]
So the real cost of the plan, will depend on the sales price of the MBS in the future (and how far that future date is). It's a big risk, but meltdown is a risk an order of magnitude larger.
NB: Later I will try and comment on the DeFazio plan.