This is what I understand the reasoning behind the bailout to be. It’s based mostly on what I’ve learned from speaking with Rhode Island Congressional candidates Mark Zaccaria and Jon Scott.
1. The bailout is not a plan to rescue anyone, banker or borrower, from bad mortgages. It’s about getting the credit market moving again.
2. The problem began with lenders creating “mortgage backed securities” based on the mortgages they held. Roughly speaking, they did the same thing as creating options on a stock. Banks and other lenders began trading these mortgage backed securities with one another, in the same manner that options are traded.
3. When the housing market tanked, many of these MBS’s that banks had put money into lost value.
4. Nobody knows how to determine the value of the different varieties of mortgage backed securities out there. More to the point, nobody knows how to reliably estimate how much you should expect to gain or lose if you have to sell your MBS portfolio a week from now.
5. Partially because of regulations related to the fact that the value of MBS portfolios have been dropping, and partially because of a real fear of future drops, banks owning MBS’s need to keep a pile of extra cash on hand, to cover the costs of sudden losses that may occur.
6. A bank can’t be loaning out the extra cash it needs to be keeping on hand. Hence the credit crunch.
7. Many “main street” businesses, to use the cliché, use short-term credit to keep their operations moving without interruption. If short-term credit is not available or its costs go up, businesses have to find some way to trim their costs, or face bankruptcy.
8. The Paulson plan, more or less, is to have the government take the mortgage-backed securities off of the hands of the banks by buying them directly. The hope is that, relieved from the threat of crashing MBS values, banks will feel free to start loaning again, and the credit market will return to its pre-crisis state.
9. But then the government would own all these exotic mortgage-backed assets that no one can accurately value.
Optimists say of the Paulson plan: Don’t worry, if the government owns a wide spectrum these MBS’s, the gains made by the “good” derivatives, over time, will cover the losses of the junk ones. (I’m not sure what the mechanism to prevent banks from dumping the really trashy MBS’s while holding on to the ones most likely to recoup their value is supposed to be).
Pessimists say of the Paulson plan: You’re telling me that buying everything in sight and hoping that there’s a net improvement in value is a workable investment strategy?
Economist Jeffrey Miron offers another perspective – why should anyone be expecting economically rational bankers to get things moving on their own, when dumping their MBS’s a day too early may cost them their slice of a big government bailout?
Any bailout plan needs to be evaluated against the entire context above
After Monday’s failure of the bailout bill in the House of Representatives John E. Mulligan of the Projo reported on the reaction from Rhode Island First District Congressman Patrick Kennedy…

“Unfortunately, the president hasn’t done a good job of explaining” the need for the rescue, Kennedy said.
“You’d want to prevent a crisis before your constituents had to feel it,” Kennedy said, “but maybe now we are going to have to find out the hard way.”