How $700 billion Paulson-Bernanke plan may help house prices

Foreclosed house for sale.

That sign has been popping up with rising frequency in front yards across America as banks unload foreclosed homes. Moreover, the distressed real estate market is causing housing prices to drop further, prompting yet more sales. It's been a vicious circle of falling real estate values.

Now the federal government is hoping to break the cycle – in essence end those foreclosure sales.

The United States, in a plan outlined Saturday by Treasury Secretary Henry Paulson, is offering to buy $700 billion worth of bad real estate assets held by banks and other financial institutions.

Will it be enough to turn around the real estate market and keep the US economy from heading into a deeper trough?

It has a good chance of getting the job done, assuming Congress can get the rescue plan passed quickly, economists say.

"We were in a vicious circle where large institutions were taking large losses on mortgage-backed securities, and when they booked those losses it involved depleting capital," says Richard DeKaser, Washington-based chief economist at National City Corp. "They either needed to raise new capital or reduce their assets further, and in this environment they were selling assets, which depressed prices further. The thrust of Paulson's plan is to mitigate the degree of write-downs." The hope, too, is that the plan will help to keep the crisis on Wall Street from further choking off Main Street.

"This should help prevent the problem from totally spilling over to Main Street," says Mark Vitner, a senior economist at Wachovia Securities in Charlotte, N.C. "The biggest threat to the economy was that more businesses were denied access to credit and it would slow overall growth even more. That is less likely now."

The cost to the taxpayer, while likely to be sizable, is not yet knowable.

"It depends on whether the securities purchased by the government [from the financial institutions] are undervalued or overvalued, and it depends on the fate of the housing market," says Mr. DeKaser.

Still, the government's plan is also likely to yield practical public benefit. A major one could be "making mortgages more affordable," DeKaser says.

News that the government was crafting a wholesale rescue plan for the financial system, rather than continuing to help firms on a case-by-case basis, turbocharged investors. On Thursday and Friday, the Dow Jones Industrial Average rose 778 points. Key interest rates have dropped, indicating that at least some lenders believe prospects have improved for getting back their loans.

"We're glad to see the markets at least have some hope," says Robert MacIntosh, who manages an $18.5 billion fund at Eaton Vance in Boston.

"It was a necessary and positive development," says Mark Zandi, chief economist at Moody's Economy.com, of the federal plan. "It shows they will do whatever it takes to shore up the financial sector."

The plan – reminiscent of Great Depression days, when the government acquired bad loans – will be taken up by Congress this week. While the government has enacted tough terms to bail out companies such as AIG Inc. and mortgage backers Fannie Mae and Freddie Mac, this plan appears to be aimed at the entire financial sector, whether a firm has financial problems or not. In fact, some financial companies might profit from the plan if they are hired by the US government to manage mortgage assets acquired from firms that sell them to get them off their books.

Congress is considering adding its own provisions to the draft bill provided by the Treasury secretary, such as helping people facing foreclosure. On Sunday, Paulson resisted such add-ons. Because financial markets remain under severe stress, the need is for Congress to act quickly without adding measures that could slow down passage," he said on ABC's "This Week." "We need to be clean and quick," Paulson said.

Despite questions about the plan's details, some economists say it was crucial for the government to devise a daring plan, in part to change the psychology of the markets.

"It had gotten to the point this week where it looked like Paulson and [Federal Reserve Chairman] Ben Bernanke had lost control of the ship," says Scott Anderson, chief economist at Wells Fargo Banks in Minneapolis. "They were just reacting to events, which seemed to be happening on a faster and faster basis. Congress had no clue what to do. Now it looks as if [Paulson and Bernanke] have taken control of events."

For some on Wall Street, normally a bastion of conservative capitalism, it is a relief to see some order restored. Last week, for example, there was a stampede by some investors to get out of money market funds. As part of its plan, the Federal Reserve is guaranteeing $50 billion in money market assets.

"That is a shaky foundation. You can't have that," says John Lekas, portfolio manager at the Leader Short Term Bond Fund in Portland, Ore. "Now, the government is working on the foundation. They are still pouring cement, but they will get the frame up in the next 90 to 100 days."

Still, working out of the problem is likely to take longer – much longer, says Doug Roberts, director of research at Channel Capital in Shrewsbury, N.J. "This is a huge problem and it will take much longer to solve than the savings and loan crisis, which took five years," he says. "This is much more complicated. It has more zeroes [in the dollar amount needed] and is global in nature."

Some worry that one ramification of the government rescue will be a falling US dollar.

"We could be facing rampant inflation, and oil is up on expectation of a weaker dollar," says Gerald Celente, president of Trends Research Institute in Rhinebeck, N.Y. "This will weaken the dollar and the credibility of the US financial markets and be a burden on the American taxpayer."

Moreover, where will the US get the money for its ventures, asks Mr. MacIntosh. "Off the bat, I would say we're going to have bigger deficits," he says. "They are already $400 billion this year, but they could grow to double that."

It's possible, however, that the US might ultimately make money on some parts of the rescue, as it did on loans it guaranteed to Chrysler Corp. in 1979. The government ultimately made $350 million on its $1.5 billion loan guarantee.

• Wire service material was used in this report.