When Congress put the final touches on a $700 billion Wall Street bailout plan, Treasury Secretary Henry Paulson was already busy at work trying to figure out which illiquid mortgage securities he planned to have taxpayers buy first.

President Bush signed the Emergency Economic Stabilization Act of 2008 on Oct. 3, giving Treasury 45 days to write rules based on the new statute. But the law authorizes Paulson to begin buying the rotting assets immediately, leaving many wondering whether the former Goldman, Sachs & Co. chief will pick up $50 billion worth of mortgage securities a month -- as he has said he would -- or spend even more before he leaves office in January. Many observers are worrying over which assets Paulson may buy, particularly if he starts picking up mortgage securities at a frantic pace.

One concern frequently voiced: As Treasury begins its work, will Paulson help out old friends before he returns to the private sector? Already, he has hired, on an interim basis, an ex-Goldman Sachs banker and Assistant Secretary of the Treasury for International Economics and Development the run the Treasury's Troubled Asset Relief Program and advise him on purchases. The Goldman ties have raised questions of conflicts, and the illiquid nature of the assets the agency will be buying make it difficult for outsiders to identify whether the price Paulson pays reflects their true value.

"If you have an asset supposedly worth between 22 cents and 77 cents and Paulson goes to one bank and says, 'I'll pay you 22 cents, because I really don't like you very much,' and then he goes to another bank and says, 'I'll pay you 77 cents for your equivalent but allegedly different security,' there isn't an easy way to identify how he valued the asset," says Rep. Brad Sherman, D-Calif.

Sherman's concerns typify worries over the purchase plan. The agency has taken steps to hike its bond sales to help pay for the $700 billion government acquisition program. But even with that step, there are nagging worries about transparency, oversight, staffing, taxes, CEO pay and how the program can help foreign owners of
mortgage securities.

Paulson has been busy hiring dozens of investment bankers, at government pay scales, to assist the agency in valuing and buying assets. Applications for securities and mortgage asset managers were due Oct. 8. "You need to hire a lot of the same guys that caused the problem, unfortunately, because only they know how to price these instruments," says David Brown Jr., partner at Alston & Bird LLP in Washington.

House Speaker Nancy Pelosi, D-Calif., on Oct. 8 sent a letter to Paulson expressing her concern over such logic. "I urge you to reconsider your interim guidelines and to strengthen them to avoid even the appearance of conflicts of interest by the same financial institutions who may also benefit [from the program]," Pelosi wrote.

The Treasury will also need to outsource a massive mortgage-servicing business because the department will not want to go to the trouble and cost of setting up a temporary internal program. When Treasury purchases a massive loan portfolio from a bank, it will need a mortgage-servicing business to bill borrowers, analyze existing mortgages and take action when there is a foreclosure. "Who hires the lawyer to do work on a foreclosure?" asks Brown. Adds one lawmaker, "There is big money in selling services to Treasury. Anytime you deal with Treasury, the crumbs are valuable."

In the coming months, it will become evident whether the purchase plan, along with all the other government strategies, will succeed at stabilizing equities and credit markets. If it meets that goal, then the taxpayer investment may be worthwhile. But it will likely remain unclear whether taxpayers will be protected from losses associated with foolish investments in mortgage securities.

The latest twist in this quickly shifting story: that Treasury may take actual stakes in banks to inject confidence in the battered system. If that happens, it would stand in stark contrast to the bailout package as it has been understood so far, and run counter to many of the ideological and strategic arguments made during its passage. For example, the statute requires Treasury to take warrants that can be converted into equity at a later date. Paulson objected to the provision, but members of Congress wanted assurances that taxpayers benefit from any recovery at a financial institution bailed out with government dollars.

It's unclear how this would be affected if Paulson simply took stakes in banks. Lawmakers have worried that the warrants might become worthless: Treasury may receive them, but if the participating financial institutions later shut down or disappear offshore, any value the security was intended to provide taxpayers will evaporate. And even though Paulson is required to take warrants in most circumstances, there is no specification about how many he should take. "He [Paulson] could get one warrant to buy one share of stock that doubles, and we get $12," says one disgruntled lawmaker. "If he doesn't want to do it, he doesn't do it."

Brown argues that it would be foolhardy for Paulson or his successor to take insignificant stakes with Congress watching. "If taxpayers get a meaningless warrant, it would cause some consternation," he says. "Paulson has some discretion, but his approach must be within the boundaries of the act."

Also, Paulson is required to take them only in certain circumstances. When Treasury buys mortgage securities valued at less than $100 million from a financial institution, he can skip the warrant. In the first draft of legislation, produced on Sept. 28, lawmakers had initially given Treasury an ability to skip warrants when it buys securities through an auction. That flexibility was dropped when Congress produced its final package the following week. Paulson had argued that when Treasury buys assets in an auction situation, price discovery would take place, and government officials should feel more comfortable that taxpayers bought the security at a reasonable price. But in the final draft, lawmakers didn't want to give the Treasury chief that kind of leeway. How they might react to using the bailout money in a nationalization scheme is anyone's guess.

Many legislators are unhappy over a provision in the law that permits Treasury to buy mortgage securities issued anywhere in the world and from any financial institution, except those owned by a foreign government. The purchase of troubled assets must "promote financial market stability," which could apply as much to foreign-held assets as to U.S.-held assets. A group of lawmakers pressed unsuccessfully to only permit Treasury to buy only mortgage securities issued by U.S. financial institutions. They worry that foreign banks with problematic mortgage securities will find ways to sell those assets to Treasury, leaving numerous U.S. financial institutions still bogged down with the securities. For instance, foreign banks could allocate billions of illiquid mortgage securities to existing or quickly created shell corporations in the U.S. with the sole purpose of unloading assets to Treasury. "That's not fair, even if we helped get them [foreign banks] into this mess," says David Sirignano, partner at Morgan, Lewis & Bockius LLP in Washington.

U.S. investment banks could be complicit in these foreign deals. One possible scenario: Goldman Sachs buys $1 billion of mortgage securities from Bank of China Ltd. on Monday and sells it to the Treasury on Wednesday. Treasury is prohibited from buying assets at a higher price than what the seller paid to pick them up, unless the securities were attained through a merger, but some observers say U.S. financial institutions can get around that provision. "You don't want to have a circumstance when all the bad investments made by Germans, all the bad investments made by Brits are bailed out by U.S. taxpayers," Sherman says.

An oversight board set up by Congress will watch Paulson's purchases in an attempt to make sure taxpayer capital isn't all spent on foreign securities. But these directors will not have the authority to halt, delay or reverse any Treasury purchases. GOP and Democratic lawmakers who opposed the government purchase plan are seeking to install former Federal Deposit Insurance Corp. Chairman William Isaac to the board. Isaac led the battle on Capitol Hill against granting Paulson and Treasury authority to buy mortgage assets with taxpayer money. Isaac, a Republican, recommended an equally controversial approach that would have involved having the Securities and Exchange Commission suspend fair-value accounting rules as an alternative to government asset purchases as a means of loosening up credit markets. The statute gives the SEC that authority, but packaged together with the $700 billion purchase plan. The SEC on its own earlier this month decided to allow companies to value assets based on their estimated future cash flow. Isaac's alternative approach failed to pass, but many critics of the Paulson plan would like to see Isaac involved in the oversight because of his skepticism.

Another sought-after taxpayer protection publicly endorsed by many key lawmakers, including Pelosi and Democratic presidential nominee Barack Obama, also may be ineffective: the provision requiring the president in 2013 to submit a bill to Congress with a tax-collection measure seeking to recoup losses from the mortgage asset purchases up to that point. Even though the president is instructed by Congress to introduce legislation that would do that, he or she might be tempted to bury the measure, for political purposes, even if shortfalls remain on the government books. The wording of the provision states that any losses would be covered by the entire financial industry, including hedge funds, brokers and other firms that don't participate in the government asset purchase program. "A bill that taxes good banks to pay for losses the government received from bad banks will not be popular," Sherman says.

Why the entire financial industry? It is almost impossible to impose the tax on the particular financial institution Treasury is purchasing assets from -- and even more difficult to apply the fee on the participating banks in proportion to the ultimate illiquidity of their assets. Sherman argues that there are no provisions in the statute that would keep track of losses on each asset purchase as it is managed by Treasury over the years. He expects assets purchased from several banks will be pooled, managed and sold together, making it difficult to know how much Treasury gained or lost on each purchase. Other foreign banks that cash in with the U.S. Treasury plan will disappear, reducing the pool of institutions covered by the tax and making it more likely that a company that didn't contribute to the financial problems will have to pay a direct fee to bail out the government.

Skeptics also worry about how taxpayer dollars will help line the pocketbooks of CEOs and lower-level executives of companies that benefit from the cash infusion. The statute imposes restrictions on the bonuses and golden parachute payments of top-level executives at financial institutions participating in the program. It also prohibits some participating companies from getting tax deductions for certain CEO pay packages. But the bill doesn't touch any CEO's base salary, which could be enlarged to offset bonus deductions.

Some of the concerns could be resolved when Treasury passes rules based on the statute, expected in November. New rules could require that a troubled asset be held by a financial institution for a set period of time, a measure that could discourage U.S. financial institutions from acting as intermediaries for foreign banks wanting a piece of the action. While unlikely, it is possible that Treasury could respond to critics and insert a provision prohibiting the purchase of non-U.S.-originated mortgage securities. More details about how Treasury plans to recoup any shortfall through taxes are likely to be included.

Other consequences of the package may not be felt for some time. For a report due April 2009, the statute requires Treasury to review the state of the regulatory system and impact of derivatives investments such as opaque cash-settled equity swaps and over-the-counter credit-default swaps. The SEC has already said that it wants more authority to regulate the CDS market. The report could put additional pressure to make that happen.

In the interim, while Paulson begins his purchases, lawmakers are warily watching both the credit and equity markets. Should the situation continue to deteriorate as it has since passage, they may take additional steps to shock the markets back to life. House Financial Services Subcommittee on Capital Markets, Insurance and Government Chairman Paul Kanjorski, D-Pa., says he is ready to do more. "I am open to other solutions to this situation," he says. "Adopting a second economic stimulus package, investing in infrastructure projects, creating jobs programs and assisting troubled companies to keep them operational should all be on the table."