As everyone by now knows, the Paulson-proposed, Congress-modified bailout deal failed yesterday in the House. The failure of the legislation led to a big dip in stocks, but some recovery has taken place today (up to about 10,750 at about 2 pm). See CNN Money, Stock Rally Speeds Up.
A few things need to be clear.
- The proposed bill was not perfect, but was better than Paulson's original proposal and could be tweaked some to be even better. The bill might be workable with three changes:
- adding bankruptcy modification for mortgages,
- remaking the oversight board to have real power and more breadth by including people outside the close-knit administrative circle such as key congressional committee chairs and possibly non-governmental organizations with a knowledge and a concern for ordinary Americans, and
- either reshaping the deal as a capital contribution for equity interests in the bank or at least requiring equity interests as part of the deal in exchange for the infusion of cash for toxic waste assets).
- This crisis was brought about primarily by two factors:
- Congress's failure to regulate swaps and other financial products and loosening of the rules on massive consolidation of financial institutions with everything under one hat and
- massive risktaking and speculation by financial institutions and hedge funds, based on the idea that there were huge profits to be made (which were made, especially by top executives and wealthy shareholders) and losses could be passed off to investors through securitizations with no fear of accountability on the horizon because of the lack of adequate regulation.
- This crisis, and lack of liquidity, is real. When there is a market disruption like this, credit freezes throughout the system, spreading like ice on a lake. First its counterparties to the big swaps (AIG) and big banks who have too many of the toxic waste securities on their own tabs (Washington Mutual, Lehmann), but then its small regional banks who offer the mortgage loans, student loans, consumer credit and working business loans to their communities. The credit freeze will affect everybody, one way or another. Banks are worried about their balance sheets, and when banks get worried, interest rates tend to rise and loans tend to get harder to get.
- The backups aren't many. The Federal Reserve has been blasting with all its weapons (and maybe a few that were not supposed to be--or thought to be--in its arsenal). But it too is at crisis level. See this Brad Setser entry at the Council on Foreign Relations, Do Not Doubt This is a Real Crisis: More on the Fed's Balance Sheet.
- Possible solutions, now that the House has not acted? Angry Bear's Robert Waldmann, in What is to be done?, suggests two (possibly concurrent) ways out of the mess, not unlike part of my recommendation on modifying the current proposal by changing it to an equity purchase.
- Preferred Shares, backed up by a contingent tax surcharge on millionaires
- Toxic, Inc., an entity into which financial institutions are required to place their toxic waste in return for equity shares