The respected Marist Poll has just reported that only 26 percent of Americans want Congress to act right away on the Paulson plan. Fully 68 percent say Congress should act, but should take the time to do it right.
This time, the people are ahead of the politicians. Paulson wanted this done in three days. Better to take three weeks. The need for urgent action was based on two assumptions that are not necessarily true.
The first was that Congress had to act — now! — or the whole system would collapse. But the assertion that the entire financial system is "frozen" is a gross overstatement. The parts of the system that are clogged up with bad mortgage paper are indeed on life support. But the rest of the system is functioning. Businesses are getting loans. Citizens are cashing checks. Home buyers are taking out mortgages. Investors are buying and selling stocks. If another big bank goes down in the next three weeks, Paulson and Bernanke will just do another ad hoc rescue, as they have done for a year.
The second assumption is that Congress is about to adjourn for the election — it's now or never. But it turns out that the senior members of the key house and senate committees of both parties all have safe seats.
So instead of racing to build on Paulson's flawed plan, Congress should appoint a select bipartisan legislative committee, made up of the senior members of the House Financial Services Committee and Senate Banking Committee and a few other respected and expert legislators. The rest of Congress can adjourn and go home to campaign. The special committee can interview experts, hold hearings, and report back with draft legislation on Tuesday, October 14, the day after Columbus Day. The full Congress can then come back into emergency session, confident that it is voting on good legislation, and act by the end of the week.
Democrats, and some Republicans, have been demanding changes to the Paulson proposal, including:
- Limits on executive compensation.
- A companion economic stimulus package.
- More help for distressed homeowners.
- An option for government to get some stock in companies it helps.
- An oversight panel to approve Paulson's proposed deals.
These are improvements. But what about the core of the Paulson plan itself? Paulson's basic idea — to have government buy up $700 billion worth of dubious mortgaged-backed securities, hold them for a time until normal markets resume functioning — is both necessary and sufficient. The plan has three larger purposes: recapitalize banks, get bad paper out of the system, and restore confidence generally so that the downward spiral ceases and the frozen credit markets unlock.
However, Paulson's approach is not the only way of fixing what's broken. At the heart of the problem is the exotic mortgages that were the underlying basis for additional layers of derivative securities. These securities include bonds backed by the mortgages, insurance contracts guaranteeing the bonds against default, etc. They are valued at many times the mortgages themselves, thanks to the miracle of leverage. As the whole show "unwinds," financial institutions and their investors are out many trillions.
One alternative to the Paulson plan is to stop the foreclosures, give at-risk homeowners refinancings at below-market rates, and pay off the existing bondholders at so many cents on the dollar. For a lot less than $700 billion, we could refinance every mortgage in America that is at risk of foreclosure. Along the way, we could keep people in their homes and shore up the collapse in housing prices. Paulson's plan does neither. Markets would begin loosening up, as in Paulson's plan, but the route would be bottom-up rather than top-down. Homeowners would be the primary beneficiaries rather than the incidental ones. With Paulson's approach, the wave of foreclosures continues, reducing the likelihood that the government gets its money back.
A second alternative is the form that the recapitalizing takes. Instead of just taking bad paper out of the system, government could assume some of the perquisites that go with investment — namely ownership. Paulson has already given every large and unregulated financial institution in America an implicit government guarantee. The FDIC, by contrast, gives explicit guarantees, but these guarantees are conditioned on regular examinations of their investment policies, their management, and the quality of their assets. When an FDIC-insured bank fails because of dumb policies, the government doesn't just buy its bad paper and give management another chance; the FDIC often takes it over and cleans it up.
As I have previously noted, the alternative to just pumping in money is to purge some bad actors as well as bad assets. The government can't take over every financial institution, but it would be salutary if it took over a few, at least as a powerful minority shareholder.
Re-regulating the whole financial system will take a little longer — it will be the job of the next administration. But Congress can at least make sure it does this interim recapitalization as well as possible. Better to do it right than to act in haste.