The only game in town

As Congress raced to a vote on the $700 billion White House plan to take the worst-performing home loans and mortgage-backed securities off Wall Street's hands, Sen. Richard Shelby last week lamented that no other options were being considered. "What troubles me is that we have been given no credible assurance that this plan will work," the Alabama Republican said at the opening of a Senate Banking Committee hearing on draft legislation submitted by Treasury Secretary Henry Paulson. "We could very well spend $700 billion or $1 trillion and still not resolve the crisis. Unfortunately, the incredibly accelerated process for considering this bill means that Congress doesn't have time to determine whether there are better alternatives -- or any alternatives."

Paulson's proposal could push the national debt to levels not seen for generations, possibly exceeding $11 trillion next year. To give a taste of what might be in store, the stock market rallied on news that a bailout was near, but the dollar on Sept. 24 slid its most ever against the euro.

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During a five-hour hearing of the Senate Banking Committee Sept. 24, Paulson said it is "difficult to determine" the ultimate cost of the plan, though he said the hope is to minimize the cost to taxpayers. Enactment requires lifting the legal ceiling on the federal debt to a record $11.3 trillion, from the current $10.6 trillion.

Congress, under the gun to pass a bill as close to last week's scheduled Sept. 26 adjournment as possible, certainly hasn't taken time to consider other ideas. And believe it or not, there are other ideas. Several economists and market experts have offered alternatives, and a handful of lawmakers incorporated some of their ideas into bills that were meant to compete with Paulson's. They were quickly pushed aside in the rush to grapple with the Bush administration's plan. The most prevalent suggestions from the academics involve calls to force debt holders to forgive some portion of financial institutions' obligations, for the federal government to inject capital into failing institutions in return for preferred stock or for raising matching private-sector investment. Other suggestions include eliminating mark-to-market accounting requirements to release the vise squeezing many companies.

The rival plans were dropped under the pressure of Paulson's relentless lobbying and dire warnings from Federal Reserve Board Chairman Ben Bernanke, who told lawmakers small business owners, automakers and middle-income Americans would soon experience a credit squeeze if the government didn't act quickly.

Questioned by Rep. Deborah Pryce, R-Ohio, Paulson and Bernanke dismissed the list of alternatives as outmoded solutions better suited to less-complicated crises of the past.

"There are a number of tactical suggestions people are dealing with -- accounting ideas, the mortgage cramdown in bankruptcy," he told her. They are the "opposite of what we want to do," he said. "We want to encourage lenders to lend for mortgages."

Injecting government capital "is the Japanese solution," which failed to pull that country out of its decade-long funk in the 1990s, Paulson argued. "They were in a very long recession for many years. They put capital in the banks, and then the government essentially was in many ways running them. We are trying to take a different approach."

Instead, Treasury aims to establish a market that will facilitate price discovery on illiquid, complex financial instruments. "That will encourage private capital to follow and makes it possible for banks to recapitalize themselves," Paulson said.

Bernanke said the competing suggestions would work better for failed institutions with traditional assets such as loans. "It's a very different situation from past episodes," he told lawmakers. Right now, the banking system as a whole is functioning, but investors won't inject capital because they have no idea what the shaky assets are worth. "More broadly, the problem is the complexity of these securities and the difficulty of the evaluation. Nobody knows what the banks are worth. Therefore it's difficult for private capital to come in and create more balance sheet capacity so the banks can make loans."

Bernanke stressed that there's nothing preventing Washington from trying alternatives if the asset purchase program doesn't get credit flowing again. "I would advise the [treasury] secretary to be flexible and respond to conditions as they change. If this process is not working properly, there are other ways to use the money to purchase assets or purchase capital and support the banking system."

If it comes to that, there's no shortage of experts ready with different ideas. Charles Calomiris, Henry Kaufman professor of financial institutions at Columbia University's School of Business and a member of the Shadow Financial Regulatory Committee, has called for government injections of preferred stock into faltering financial institutions. Modeled after the Depression-era Reconstruction Finance Corporation, it would avoid the complications of pricing subprime instruments for purchase. Calomiris and others have warned that Paulson's approach risks setting prices either too low, thus denying selling institutions needed capital, or too high, which would harm taxpayers.

Preferred stock assistance would limit taxpayers' loss exposure, he says, and leave the task of managing assets to the market. Supporters of the idea point out that is essentially the approach taken with Bear Stearns Cos. and American International Group Inc.

Douglas Elmendorf, a senior fellow at the Brookings Institution and a former senior economist at the White House Council of Economic Advisers and senior official at the Treasury Department and Federal Reserve Board, has offered a couple of different approaches. One would have the government make equity investments in a wide cross-section of financial institutions. That approach would also avoid having the government guess the appropriate prices and quantities of individual mortgage-related securities, and, he says, it would not end up providing outsized awards to companies that made the worst investments. It also has the benefit of offering taxpayers a chance to earn a higher return if the financial system has a strong recovery.

The Center for American Progress argues that the government should tackle what it calls the root cause of the problem: the glut of foreclosed properties across the country. The group has proposed establishing a fund, which it dubs the Great American Dream Neighborhood Stabilization, or Gardns, Fund, to help municipalities or local nonprofits purchase foreclosed properties and offer them for sale to qualified low- and moderate-income families on affordable terms. Proceeds from the sale would be used to purchase additional properties, thus multiplying the fund's purchasing power.

Jack M. Guttentag, professor of finance emeritus at the Wharton School of the University of Pennsylvania and founder of mortgage technology company GHR Systems Inc., urges a loan program that would provide cash to firms with acceptable collateral. The program could be administered by the Federal Home Loan Bank System, which would act as reserve banks for mortgage lenders. He notes they have the benefit of established systems for valuing and monitoring mortgage collateral. Although Federal Home Loan Banks currently lend only to members of the system, he says participation in this program could be extended to any institution -- even hedge funds and foreign firms -- that post acceptable collateral.

To discourage program participants from relending at a profit, the government would charge an interest rate high enough to make it impossible. In fact, he says, the government would make the profit because the loan rates would substantially exceed the government's cost of funds. Profits generated by the higher rates could be funneled into the federal Hope Program for modifying distressed mortgages or similar programs.

Amid all the talk of financial Armageddon, there are also those who say no bailout is necessary. Liberal economist James K. Galbraith pointed out in The Washington Post on Sept. 25 that all five major investment banks have either gone bust or transformed into commercial banks, and those are eligible to hold federally insured deposits. "The point of the bailout is to buy assets that are illiquid but not worthless," he wrote. "But regular banks hold assets like that all the time. They're called 'loans.' " Now that the remaining institutions are commercial banks, he suggests outflow of capital can be stemmed by eliminating the "pointless" $100,000 cap on deposit insurance provided by the Federal Deposit Insurance Corporation. With investors' minds at ease, the FDIC will have time to burrow into the institutions' loan portfolios. At those declared solvent, "money market funds would flow in." The FDIC could shore up insolvent ones with its bridge bank facility.

As for the $700 billion Paulson wants, Galbraith has ideas for that too. To boost confidence in the FDIC, he suggests injecting the deposit insurance fund with a half-trillion dollars. The Treasury could keep $200 billion in reserve so it can recapitalize banks if necessary by buying preferred shares. With the systemic threat removed, Washington could then shift its attention to a multiyear effort to repair the housing market and invest in local infrastructure and renewable energy.

The various suggestions influenced several legislative alternatives, but the sponsors ditched them almost immediately once it became clear that Paulson's plan would be where the action is.

New York's Sen. Charles Schumer led off with a rival bill that uses a different model than Paulson's. Schumer's plan, unveiled Sept. 18, was adapted from the Reconstruction Finance Corporation model endorsed by Calomiris. An RFC-style government agency would provide capital to struggling financial institutions in exchange for an equity or preferred-stock stake in the banks. It also would require participating institutions to accept loan modifications by bankruptcy judges.

Senate Banking Committee Chairman Christopher Dodd, D-Conn., on Sept. 22 introduced a bill that would grant the Treasury authority to buy distressed assets but also would require the agency to take a portion of any profits it earns from their sale and put them into the Hope affordable housing program. He also includes authority for bankruptcy judges to restructure mortgages for homeowners facing foreclosure. Dodd and Schumer didn't focus on their legislation but pushed the White House to include mortgage-workout provisions and other add-ons in its bill.

Like many conservative Republicans, Rep. Thaddeus McCotter is adamantly opposed to Paulson's bailout. The Michigan lawmaker is chairman of the Republican House Policy Committee, a leadership advisory group. McCotter is also a member of the House Financial Services Committee. His bill, dubbed Earn for Expedited American Recapitalization -- Now act, would make available to financial institutions a prepackaged recapitalization proceeding in which debt forgiveness is a component. Investments in troubled assets or financial institutions that undergo an Earn proceeding are eligible for a zero capital gains tax rate for the life of the investment. If no private capital is forthcoming, the government can take a preferred equity stake in an Earn financial institution. No dividends may be paid to any other investor until the taxpayers' claim is redeemed with "appropriate" interest. The government will also hold voting rights in an Earn financial institution proportional to its equity shares owned. McCotter notes that voting rights allows the government to have a voice in CEO compensation without eliminating boards of directors' authority to set pay. To assist distressed homeowners, 5% of any government infusion must be used to reduce the face value of "toxic" mortgages. For troubled assets, his bill would suspend the current mark-to-market rule and replace it with a three-year rolling average mark-to-market; and for a fee, insurance on these assets could be purchased from the federal government.

Sen. Hillary Clinton, D-N.Y., on Sept. 23 laid out "next steps" for dealing with the crisis. She is calling for the creation of a new Home Owner's Loan Corporation, or Holc, modeled after another Depression-era agency, to carry out mortgage modifications. She warns that 2 million homeowners carry mortgages greater than the current market value of their homes. Modification would give the homeowners new fixed-rate mortgages with payments they can afford. Clinton also wants a temporary moratorium on foreclosures and a temporary freeze on rate hikes for adjustable-rate loans. She is also calling for implementation of a Federal Housing Administration refinancing initiative passed into law this summer. She favors an equity component for the government as part of the initial bailout package and wants prices of mortgage securities bought by taxpayers to be disclosed in real time in order to prevent the program from being abused.

Given the likelihood that the administration would get the bulk of what it wanted, such proposals may be the starting point for the next wave of attempts to resolve the crisis.

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