Time: 18 Tough Questions (and Answers) About the Bailout

Where will the $700+ billion go? What exactly will it buy and from whom?That's the, uh, $700 billion question. Mortgage-backed securities were to be the main target, and banks the main sellers. But Hank Paulson and Ben Bernanke wanted a fund that could buy pretty much anything from anyone.

How, exactly, is this bailout supposed to 'save' credit markets?Not entirely clear. Paulson and Bernanke described it as a way to jumpstart trading in mortgage securities for which there's no market at the moment, thus allowing banks to clean up their balance sheets and get back to lending. But a lot of economists outside government believe that the real problem is that lots and lots of financial institutions are insolvent--their losses, if they actually recognized them, are enough to wipe out their capital reserves. If that's true it would make more sense for taxpayers to give them cash outright, and take a big ownership stake in return (with the idea of selling it off a few years down the road). The Swedish solution, they call it (and longtime readers of this blog know it was being discussed here long before anybody else in the U.S. was talking about it). The version of the bailout plan voted down in the House Monday seemingly would have allowed Treasury to take such action. But it also would have allowed Treasury not to take such action.

How/why is this situation different from investors simply losing their money because of bad judgment about what to invest in? Can I get bailed out when my portfolio tanks?It's a variant on the old saw (often attributed to J. Paul Getty, although I'm sure somebody must have said something like it before him): "If you owe the bank $100, that's your problem. If you owe the bank $100 million, that's the bank's problem." Leveraged financial institutions (banks, investment banks, hedge funds) make investments with lots of borrowed money, so when their portfolios tank they can quickly get into a situation where they can no longer make good on their debts. When that happens to a single institution, it's no big deal to let it fail. But if it's happening to a lot of them at once, you get the paradox of deleveraging: a downward spiral in which failure begets more failure and retrenchment begets more retrenchment.

Why should Wall Street be bailed out? Won't it just make them all the more eager to engage in risky practices in the future? Are we bailing out the very people who created the problem?A lot of the people who created the problem have already lost their jobs, but yes, any bailout risks rewarding the profligate and the foolish. But we're getting to the point where financial sector problems are starting to hurt people who didn't profit from the boom. And you can design a bailout that's not so much a bailout as a new start--such as the Swedish solution outlined above.
There's also the approach favored by the late MIT economist Charles Kindleberger, who thought it was the job of governments and central banks to step in and halt panics, but felt they should "always leave it uncertain whether the rescue will arrive in time or at all, so as to instil caution." That seems to be official U.S. government policy at the moment, actually.
If more currently outstanding mortgages default, won't the problem just keep going on and on?Yes, that's a big part of the concern at Treasury and the Fed. That economic trouble emanating from the financial system will cause even more people to fall behind on their mortgage payments which will lead to even more trouble in the financial system.