The Bailout: An Owner's Manual

Washington, D.C. -

Congratulations. If you're an American taxpayer, you've just become the owner of a brand-new $700 billion attempted bailout of the U.S. financial system. After a 263-171 vote by the U.S. House of Representatives Friday, President Bush signed the legislation, aimed at rescuing the freezing credit markets in an effort to shore up the failing economy.

Actually, it's a bit bigger than $700 billion. The version of the bill that passed Friday contains some expensive add-ons, including a provision that keeps the alternative minimum tax (AMT) from encroaching upon the middle class in 2008, clean-energy tax incentives, disaster relief and the extension of expiring tax cuts for businesses and individuals. It also expands government insurance on bank deposits from $100,000 to $250,000 through 2009.

You probably have questions. So do we. A guide:

How does it work?

The bailout plan gives the Treasury extremely broad authority to buy up to $700 billion in troubled assets, like mortgage-backed securities, from firms that are having difficulty selling them. Uncle Sam can also insure these assets instead of buying them.

The idea is to get these securities off firms' books--or at least give them a government guarantee--so that these businesses can more easily lend and borrow again. Only assets that were originated on or before March 14, 2008, are eligible. The Treasury has through 2009 to use the funds.

Once the bill becomes law, the Treasury will hire a team of consultants and managers to help the government figure out what to buy. This group will also assist the Treasury in determining how to price the assets, which are now tough to value. The most likely scenario is an auction. The Treasury could sell the securities for a profit at a later date.

Am I paying for this?

If you pay taxes then yes, absolutely. The real question is whether you'll be getting the money back. The answer to that probably won't be known for years, after the government has sold most of the assets it's getting ready to buy. "In principle, we could make a profit," says Martin Baily, a former chairman of the president's Council of Economic Advisers and now a senior fellow at the Brookings Institution. But if there's a net loss, five years from now the president will have to come up with a plan to recover the shortfall, which could put taxpayers more deeply on the hook. "That would have to be recognized on the budget over time as the value of those assets becomes clear," Baily says.

Will it affect home prices?

Depends how successful the bailout is. If it helps get credit markets operating properly again, housing prices may stabilize, but it could be a while before demand catches up to supply. "Throughout the last decade, we didn't make home prices more affordable; we made money cheaper," says Brant Imperatore, a financial services consultant for lobbying firm BGR Holding in Washington, D.C. Even if the bailout works and home prices start to rise, don't expect banks to lend as liberally as they were doing during the last several years.

But keep an eye on mortgage buyers Fannie Mae (nyse: FNM - news - people ) and Freddie Mac (nyse: FRE - news - people ), now under the government's control. Peter Wallison, a fellow at the American Enterprise Institute, says to expect Fannie and Freddie to buy more mortgages, which could free up lending in the primary mortgage market. "Every resource that the government has at its fingertips it is going to use," he says.

What about oversight?

The Treasury secretary would periodically submit to Congress a detailed report of the bailout's progress, including all financial transactions and the "types of parties involved." In addition, every quarter, a special inspector general would provide Congress with a report including all purchases made and income received from the bailout.

How much will it cost?

The initial addition to the federal debt would be $700 billion, although the Congressional Budget Office believes the net budget loss will be "substantially smaller" because the government can recoup some of its losses and perhaps sell the securities for a profit later. There are also administrative costs, which the CBO currently estimates at perhaps "a few billion dollars per year."

However, the newly added tax provisions of the bill alone will cost the government an additional $110.4 billion by 2018, according to a just-released study by Congress' Joint Committee on Taxation. Only $3.4 billion of that is related to the "bailout" portion of the bill. The AMT fix and the extension of certain tax incentives will cost $107 billion over the next 10 years. The energy provisions are completely paid for.

Is it big enough?

Probably. The administration asked Congress for $700 billion, thinking that was a large enough number to restore confidence to the markets, clean up the balance sheets of troubled companies and prevent it from asking for more. One thing that might help: Under the current version of the bill, banks issue the Treasury stock warrants, giving taxpayers a chance at making money once the crisis subsides.

That isn't going to be the only remedy, though. Already the Federal Deposit Insurance Corp. (FDIC) has stepped up its oversight of troubled banks, and the agency is taking a more aggressive view to recapitalizing banks or forcing mergers of strong banks with weak banks before they fail.

The Federal Reserve is also playing its part. It is pumping hundreds of billions into the banking system--nearly $1 trillion in actions announced this week--to help alleviate the pressure on balance sheets as banks reduce their leverage. The Fed will continue to flood the system with money through the next few months, with the year-end balance sheet preparation looming.

What happens to the companies who participate?

They will have to give the government the ability to acquire shares and executives at the companies will be subject to more restrictive compensation rules. There is the possible stigma of participating, since it may make them appear to be weak. But if everybody does it. ...

So who will use it and who won't?

Joshua Siegel from StoneCapital Partners, a New York private equity firm that invests in small banks, says the regional banks stand to gain the most from the plan. That is a group that includes National City (nyse: NCC - news - people ), Fifth Third (nasdaq: FITB - news - people ), Sovereign, Colonial BancGroup (nyse: CNB - news - people )--all companies whose shares have been pounded down in the market tumult. In addition, the American Bankers Association has pressed to make sure it's available to all 7,000-plus banks, not just those with big mortgage exposure.

But will the big banks use it? "They could say 'I can make it without it,' " Siegel says, "or they could take a little" and see what happens. Citigroup (nyse: C - news - people ), which is vying with Wells Fargo (nyse: WFC - news - people ) to buy Wachovia (nyse: WB - news - people ), still has more than $500 billion of assets it wants to unload gradually. JPMorgan Chase (nyse: JPM - news - people ) is taking on Washington Mutual (nyse: WM - news - people ) and its $310 billion in assets. Bank of America (nyse: BAC - news - people ) is dealing with absorbing Merrill Lynch (nyse: MER - news - people ) and Countrywide Financial (nyse: CFC - news - people ).

JPMorgan CEO James Dimon supports the plan but says he's not inclined to use it. Though he may change his mind after it becomes clear just how the program is going to work.

What's the best case scenario for the bailout?

That credit markets start functioning properly again, and the government can turn a profit on the sale of the assets it buys. The former scenario will become evident in the next several months, the latter could take years.

That doesn't mean the U.S. economy will become healthy again overnight, however. Stephen Auth, chief investment officer for Federated Investors (nyse: FII - news - people ), says to expect more bad economic news for at least the next couple of quarters, including unemployment levels at 7% or higher. "This is going to throw up a breakwater and keep it from swamping the whole system," he says of the bailout.

What's the worst case?

It simply doesn't work. Credit markets remain gummed up, borrowing and lending for consumers and businesses of all sizes comes to a halt and banks continue to fail. That could lead to a prolonged recession. There's also the possibility that the expansion of insurance caps on bank deposits won't do much to help small businesses, which typically need to insure more than $250,000.

In addition, if the government can't make any money from the purchase of these assets, it saddles Americans with more debt and higher interest rates, perhaps for years to come.

Is there a Plan B?

No. Once Congress passes a bailout package, it will almost certainly not give the administration any more money to rescue the economy.

But there are other ways to help the banking system help itself. For example, Citigroup announced it would buy Wachovia's deposits, assets and holding company debt for $2 billion in a transaction assisted by the FDIC. The government is providing a backstop on all but $42 billion of Wachovia's $312 billion of risky assets.

There's no reason the FDIC can't help structure other transfers like this, with no cost to its deposit fund, protection for all general creditors and limited exposure to taxpayers. "This does not require legislation," says William Isaac, the former FDIC chairman who used a similar technique to rescue Continental Illinois from failure in the 1980s. "The FDIC already has been granted this authority. It just needs to use it."

How will we know if it is working or not?

Several indicators will be of use, according to Auth of Federated Investors. Right now, the London Interbank Offered Rate (LIBOR)--a rate banks charge each other to borrow--is at a record high, around 5%. Once it starts to come down, that's a good indication that credit markets are starting to function properly again. Same goes for "TED spreads"--the difference between three-month contracts for Treasury bills and eurodollars.

In addition, Auth says more capital moving into the financial sector is an indication that the bailout is a success. That's already started to happen, as indicated by Warren Buffett's recent investments in General Electric (nyse: GE - news - people ) and Goldman Sachs (nyse: GS - news - people ).