On Wednesday, lawmakers asked Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke to justify the administration’s claims that drastic action is urgently needed to unfreeze credit markets.

Paulson and Bernanke were also pressed to modify their plan to provide more help for troubled homeowners and protections for taxpayers when they testified before the House Financial Services Committee.

“We’ve all heard ‘Why Paulson is wrong,’ ” said Rep. Deborah Pryce, R-Ohio, referring to a widely cited article by University of Chicago professor Luigi Zingales. “What we need to hear today is why Paulson is right.”

Zingales maintains that “the Paulson plan” will stop the financial crisis, but only by “creating a charitable institution that provides welfare to the rich” at taxpayer expense.

Many lawmakers, having heard similar complaints from outraged constituents, are echoing Zingales’ call for a debt-for-equity swap in which taxpayers get an ownership share of companies that are helped.

Bernanke and Paulson maintain that the time has passed for case-by-case government intervention to help failing or soon-to-fail companies like Fannie Mae, Freddie Mac and insurer AIG in exchange for an ownership stake.

By buying up assets that banks and financial institutions can’t get off their books — including securities backed by risky mortgages — the Bush administration hopes they will be able to raise more capital and continue making loans that are the lifeblood of the economy.

The credit crunch that began last summer now threatens to restrict lending to everyone from big corporations to small businesses and consumers seeking loans for college or cars. That, in turn, could produce further drag on an already slowing economy and send unemployment up, the administration maintains.

The government’s new plan is to buy distressed assets, such as mortgage-backed securities, through means such as reverse auctions. In a reverse auction, banks and financial institutions would compete with each other for pools of money by selling assets that they would mark down from their face value. The Treasury would analyze the offers, and purchase the assets it considered the most competitively priced.

In order for the plan to work, Paulson said, participation from a large number of institutions offering a broad range of assets is needed — not just companies facing bankruptcy and trying to unload their riskiest loans. Instead of putting capital in institutions that are troubled, the government is taking a different approach.

“We’re trying to have price discovery on illiquid assets that encourages private capital to follow, and allows banks to recapitalize themselves,” Paulson said.

Demands by some lawmakers that the government require participating institutions to give taxpayers equity interest or place restrictions on executive compensation would limit participation in the auctions and limit the plan’s effectiveness, Paulson said. The best way to protect taxpayers, Paulson said, is to prevent a bigger meltdown that could threaten retirement savings plans and choke off businesses’ access to loans.

Another Ohio Republican, Rep. Steven LaTourette, told Paulson and Bernanke he understood those arguments, but that they needed to explain it in terms a “guy on the couch” in Cleveland could understand.

Paulson said that although officials do not want to scare the public, “the fact is that if financial markets are not stabilized, the situation can (become) very severe.” The guy on the couch could lose his job, his retirement savings and his ability to borrow, Paulson said.

“He should be angry and he should be scared,” Paulson said. “I think right now he’s more angry than scared.”

In his televised speech, President Bush also stressed the implications of a financial meltdown for ordinary Americans.

Without immediate action by Congress, America could slip into a financial panic, Bush warned.

“More banks could fail, including some in your community,” the president said. “The stock market would drop even more, which would reduce the value of your retirement account. The value of your home could plummet. Foreclosures would rise dramatically. And if you own a business or a farm, you would find it harder and more expensive to get credit.

“More businesses would close their doors, and millions of Americans could lose their jobs. Even if you have good credit history, it would be more difficult for you to get the loans you need to buy a car or send your children to college. And ultimately, our country could experience a long and painful recession.”

Rep. Paul Kanjorski, D-Ohio, asked about media reports that the Treasury plan was spurred in part by a $500 billion run on money market funds on Sept. 18, with the Fed pumping $105 billion into the system to prevent a panic.

“The public needs to know an electronic run on money market funds is no different than a bank run in 1929,” with results that are potentially equally catastrophic, Kanjorski said.

Paulson did not dispute Kanjorski’s account, saying money market funds are the source of $1.7 trillion in short-term loans that businesses depend on to fund daily operations. To stem the run, the Bush administration used emergency powers to insure deposits placed in money market funds through Sept. 19 for one year.

Banks that compete with money market funds for deposits have complained that the government’s decision gives money market funds an unfair competitive advantage. Paulson said that because new investments in money market funds aren’t covered by the insurance, the government has not created an “unlevel playing field going forward.”

Other lawmakers also had concerns about the fairness of the administration’s bailout plan and whether it would benefit some at the expense of others.

Committee Chairman Rep. Barney Frank, D-Mass., questioned whether smaller community banks would be “lost in the shuffle” of the Treasury plan. Lenders who made fewer bad loans would be less likely to have assets to unload on the government than those who were more reckless, Frank said.

Paulson said that the Treasury plan envisions participation by “hundreds, or even thousands, of institutions,” including community banks, credit unions, and savings and loans.

Community banks have already taken a hit by the government’s decision to place Fannie Mae and Freddie Mac in conservatorship, Frank said, because many held preferred stock in the companies that was devalued when the government took a stake in them. The Massachusetts Democrat said he will support legislation that would give holders of Fannie and Freddie preferred stock a tax break by letting them write down the full value of their losses right away.

“They were the ones least responsible for the problem — we can’t make them the victims,” Frank told Paulson and Bernanke. Frank also promised to support raising the $100,000 limit on Federal Deposit Insurance Corp. coverage of deposits at federally chartered banks and savings and loans to help them them grow deposits.

With the breakdown in the secondary market for mortgage loans not backed by Fannie, Freddie and FHA, community banks are playing a crucial role in funding “jumbo loans” that exceed the $729,750 limit on the government sponsored entities, or GSEs.

That will be even more true after Jan. 1, when the conforming-loan limit for high-cost markets drops to $625,000, said Tom Millon, president of Capital Markets Cooperative.

“There are a few sort of largish regional banks out there that are buying jumbo paper today … but it’s really just become a local, retail business if it exists at all,” Millon said.

Millon’s Ponte Vedra Beach, Fla.-based firm helps clients, including about 50 community banks, sell mortgages in the secondary market. The lack of demand by investors for securities backed by jumbo loans means borrowers who can get them are paying higher interest rates.

“The community banks are earning some very nice returns lending to their best, local customers,” Millon said. If the Treasury plan “got the juices flowing” in the jumbo market — perhaps even generating enough confidence for investors to resume their purchases of private-label securities backed by jumbo loans — “that would be a very good thing” for consumers.

But the plan might not have much impact on jumbo loan rates if large lenders don’t use their increased capital cushions to boost originations and purchases of jumbo loans.

“The larger players could just keep the capital and do nothing, and there would be no change in the competitive landscape” for jumbo loans, Millon said. “But a Citi or SunTrust, if they got rid of (millions of dollars in) bad loans, I think they’d probably put a few more prime jumbo loans on their balance sheets, and that’s probably good for the consumer — it gets the wheels turning in what is somewhat of a dead space right now.”

All in all, the plan looks to Millon like something that would benefit “the much larger players,” but perhaps leave smaller community banks at a competitive disadvantage.

“In the jumbo space, liquidity is coming,” but probably not until well into 2009, Millon said. “A lot of smart people are trying to figure out solutions.”

Although Millon said he and others at his firm are skeptical that the Treasury will use wisely whatever money Congress eventually authorizes, “now that the prospect of this sort of plan is out there, it would probably be catastrophic to see something not happen” at all, he said.

David Zugheri, co-founder of First Houston Mortgage, agreed that while the Treasury plan may have its faults, it’s needed — and sooner than later.

“A good plan today versus a very good plan a year from now? They have to take the good plan today,” Zugheri said.

Paulson said today that he expects the program’s cost to taxpayers will be “minimal” because the government will be able to hold many of the assets it buys and sell them at a higher price when housing markets recover. While the government could theoretically make money buying and selling distressed assets, “I’m not going to say that (will happen) because I just don’t know,” Paulson said.

Zugheri, a mortgage industry veteran whose First Houston Mortgage is licensed to lend in 20 states, said he expects the government will take a loss on many of the worst assets it buys. But should the government selectively hold some of the best mortgage-related assets, and if housing markets come back “in two, three or five years, all these problems go away,” Zugheri said.

“The government is kind of hedging that it can hang on to some of these. Cycles tend to last 10 years, and Paulson is saying, ‘I know it looks bad right now,’ but he does think the taxpayers will end up making money. He’s short of saying that, but he’s sure there’s a scenario where taxpayers come out ahead,” Zugheri said.

In an opinion column published in the Washington Post, PIMCO managing director Bill Gross estimated the Treasury Department will be able to buy distressed mortgages for 65 cents on the dollar, and earn double-digit returns if it hangs onto them for long enough and keeps foreclosures in check.

Gross, who is hoping to manage some of the assets the government buys, said that because of the write-downs investors who sell assets to the government will take, the Treasury plan “is a Wall Street-friendly package only to the extent that it frees up funds for future loans and economic growth.”

If you’re right, you can claim it and tout it on your resume for the rest of your career.

I’ve certainly been asked the “bottom” question like a gazillion times. We should learn from the prior conversation, which was “calling the top.” In the prior scenario economists and pundits got lots of air time doing this. Call the top for several years and eventually you’ll be right. Consistency is a virtue.

Bob Toll said:

“People are looking for a reason to get off the fence. The most asked question in America today other than who Obama’s Vice President is going to be is probably when is the bottom? And if you even smell as though you are in real estate, people ask you that question all day long.”

Let’s have that real estate conversation now:

Q: When is the housing market going to bottom?
A: I don’t know.

One thing I do know, it is not going to be this year. And so what?

What does “calling a bottom” do for anyone, anyway? …especially if it’s only a gut feeling. Yun of NAR has been calling for a bottom more times than I care to recite and even his most loyal fans are getting numb.

The idea that we want to have finality with the problems of the housing market is certainly understandable. When someone is stepping on your foot, you’d like to get an idea when they’ll get off of it.

We simply need to know. Or as said in the movie “Dirty Harry” by a criminal who was staring down the barrel of a 44 magnum (the most powerful handgun in the world) …”I gots to know.”

“V” versus “L” shaped bottom
My biggest issue with the answer to this question is that it is misleading. To most consumers, the “bottom” means the end of housing market stress and it marks the point where things will get better. Trough to peak.

Have you looked at the credit situation lately? The health of the GSEs?

Calling a “bottom” today likely means the point where things stop getting worse. And a flat bottom could stick around for a number of years. Think about it. What constructive actions to restore faith in the credit/investor/financial markets which provide liquidity for mortgages have occurred since last summer?

Steep and Deep, Short and Shallow
Another issue that is clearly perverse and often baffling in the answer to the “bottom” question concerns the vastly different performance characteristics of each market. There is no national housing market.

Some markets will see the housing market deterioration as steep and deep, others will be short and shallow, and the remainder in between. While all markets are connected by credit and mortgage quality and quantity, local conditions rule. I think the upturn in Michigan, with it’s auto industry woes, is much farther away than south Florida, the current poster child for rampant speculation and five year inventories of the past several years.

I’m looking forward to getting to the bottom of the bottom discussion. Please.