I have two concerns about Treasury Secretary Henry Paulson's plan, one substantive and the other political. The first is that it might not work -- and we will have used up $700 billion of public money and be that much worse off. The second is that it won't work, but Democrats will have gotten enough of their demands met that the Republicans will spin the failure as the Democrats' fault.
So here is my suggestion: Congress should not be herded into acting until lawmakers think harder about the entire approach and its alternatives. 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. Homebuyers 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. Better to do this general overhaul right than to do it in great haste.
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 here is the Kuttner plan, as a wiser alternative to the Paulson plan:
Congress appoints a small 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 adjourns and goes home to campaign. The special committee interviews experts, holds hearings, and reports back with draft legislation on Tuesday, October 14, the day after Columbus Day. Congress comes back into emergency session and acts by the end of the week.
Paulson's tactic of demanding instant action because impending catastrophe recalls how the same Bush Administration rushed through the USA PATRIOT Act. But there are two key differences. After 9/11, American citizens were terrified and willing to give the Bush administration whatever it wanted. And Congress totally caved. This time, citizens are frightened -- but not gulled. Congress is hearing from constituents that the Paulson plan is an outrage. The easy vote is to oppose it.
So let's stipulate that Democrats get the other major provisions that the public interest requires. These include:
- 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.
But what about the core of the Paulson plan itself? Here, Congress needs to think outside the box. Paulson's basic idea is 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 that the exotic mortgages that were the underlying basis for additional layers of derivative securities are, to use the technical term, crap. 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.
So one alternative to the Paulson plan is to stop the foreclosures, allow at-risk homeowners to refinance 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.
But don't take my word for it. Spent three weeks taking testimony from dozens of experts and compare the two scenarios. Hold comprehensive hearings before you legislate. Imagine that.
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. The best expert witness here is Sheila Bair, who heads the FDIC. Paulson has 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. No, 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.
And here is one final suggestion, which can be described as constructive mischief. The committee should invite testimony, with plenty of unscripted questions and answers, from Barack Obama, John McCain, Joe Biden, and Sarah Palin. And the unscripted responses of Sarah ("One-Heartbeat-Away") Palin should be aired live, in prime time.
