Slow Down and Get This Right

Physicists, historians, and economists talk about "path dependence." Something that is far from ideal persists, only because we are stuck with a particular path. A favorite example is the QWERTY typewriter -- it is far less efficient than other arrangements of letters, but we all learned on it and are too lazy to change. Another is employer-provided health insurance. No reasonable person would design such a system for today's economy, but we're stuck with a whole infrastructure that resists reform.

Watching the Democrats and the Paulson hearings, I thought of path dependence. Paulson has defined the path. Democrats, many Republicans, and really angry constituents don't like this plan, but legislators haven't quite mustered the nerve and imagination to propose a wholly different approach. They have bought Paulson's argument that something has to be done very fast, and the most they can think to do is add embellishments. That's not good enough -- and there are whole other paths.

My worries are both substantive and political. If the plan doesn't work, we are out $700 billion and the crisis of confidence will deepen. And Democrats may well get enough of their demands met that the failure could seem their fault rather than that of the plan's core approach.

Congress should not be stampeded into acting. Lawmakers should take more time to think about alternatives. The need for urgent action was based on two faulty assumptions.

The first was that Congress had to act-now! -- or the whole system would collapse. But wait a minute. Some parts of the system are indeed clogged with bad mortgage paper. But businesses are getting loans. Citizens are cashing checks. Homebuyers are taking out mortgages. Investors are buying and selling stocks. If another big bank faces a crisis in the next three weeks, Paulson and Bernanke will just do another ad hoc rescue.

The second assumption is that Congress must adjourn this week or next. But the senior members of the key committees of both parties all have safe seats.

So consider the Kuttner Plan, as an alternative to the Paulson plan:

First: Congress creates a select committee made up of senior members of the House Financial Services Committee and Senate Banking Committee and a few other expert legislators. The rest of Congress adjourns. The special committee interviews experts, holds hearings, and reports back Tuesday October 14, the day after Columbus Day. Congress comes back into emergency session and acts by the end of the week.

Let's assume 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 further outside the box. Paulson's basic concept is that government buys $700 billion worth of dubious mortgaged-backed securities and holds them for a time until normal markets resume functioning. He contends that this approach 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 many of the exotic mortgages that were the underlying basis for additional layers of derivative securities are not going to be paid back. These securities include bonds backed by the mortgages, insurance contracts guaranteeing the bonds against default, and other exotic kinds of "derivatives." They are valued at many times the mortgages themselves, thanks to the miracle of leverage. But as the leverage goes into reverse, the capital of many investors such as banks, insurance companies, and investment banks is being wiped out-far beyond the underlying value of the mortgages.

Paulson's approach is top-down-rescue the banks. But it's actually more efficient to rescue the homeowners by stopping the foreclosures. Refinancing the mortgages would allow the bondholders to recoup some percentage of their investments. 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.

Congress should spend three weeks taking testimony from dozens of experts, and comparing the two scenarios. Hold comprehensive hearings before you legislate. Imagine that.

A second issue is what form the recapitalizing should take. Instead of just taking bad paper out of the system, government could assume get some rights of ownership for its $700 billion. Consider, as a counter-example, 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. The government can't take over every failed financial institution, but it would be salutary if it took over a few, at least as a powerful minority shareholder.

For the long term, which means early in the next administration, Congress needs to re-regulate America's financial markets, so that this sort of needless crisis is never repeated. For now, it needs to get this emergency rescue done right. It cannot possibly do that rescue in a week.

If Paulson's arrogant tactic of demanding instant action because of impending catastrophe sounds vaguely familiar, it's because it evokes how the same Bush Administration rushed through the USA Patriot Act. But 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 also outraged and less easily fooled, and they're holding Congress's feet to the fire to slow down, not to speed up.

The select committee should invite testimony from both presidential candidates and their running mates. That would be Barack Obama, John McCain, Joe Biden, and Sarah Palin. The responses should be unscripted, and aired in prime time. Especially Palin's.

Robert Kuttner, co-editor of The American Prospect and Distinguished Senior Fellow at Demos, has just published Obama's Challenge: America's Economic Crisis and the Power of a Transformative Presidency (Chelsea Green). He is blogging daily about the election and the economic crisis at www.obamaschallenge.com.

Comments

[Hegemoneyhoney]

During the hearings yesterday with Paulson, Bernanke, et al. dictating terms to the American taxpayers, the news banner at the bottom of the TV screen reported the cheating NBA referee was sentenced to prison for throwing NBA basketball games. What irony. The CEOs, CFOs, Board members, brokers, bankers, house flipping cheaters, graft-loving members of Congress, and the greed-mongers whose self-enriching flim-flamming smells of treason will have what happen to them exactly? For their greed, fraud and deception, the robber barons of Wall Street and the greedy scammers of "Main Street" will have what troubles? Republicans AND Democrats have dirty hands in this and a pox on both their houses! We need real reform!! Stop defining "Main Street" by the greedy behavior of the mortgage cheaters. Main Street is really the people who live within their means, pay their bills and live in houses they can afford, and they don't ever expect their neighbors to pay off their gambling debts!! The people who are supposed to "fix this mess" need to heed Robert Kuttner, William Greider, et al. and they should also take a refresher course in the U.S. Constitution, the Bill of Rights and the Declaration of Independence! McCain, Bill Clinton, Cheney, Bush I, Bush II, too many members of Congress, their corporate and financial cronies...­. grasping totalitarian oligarchs who would destroy America for their own selfish ends. What have they wrought?

[beef33]

truer words never spoken

[AnotherV]

"Give me the right to issue and control a nation's money and I care not who governs the country." Meyer Amschal Rothschild, International banker

[ohjoy]

I feel sick.

I was going along feeling like I was in the Twilight Zone with the Mcdesperate.

Now it seems more like a Wes Craven horror film.

[Bluebayou101]

George Soros wrote in the Financial Times that instead of trying to value these mortgage-related assets (which is difficult) and purchasing them directly, the US should be identifying the troubled companies and purchasing equity (easier to value) in them (an equity stake for the taxpayer); this should stabilize those institutions by injecting cash into them.

Soros also suggests that "To prevent housing prices from overshooting on the downside, the number of foreclosures has to be kept to a minimum. The terms of mortgages need to be adjusted to the homeowners’ ability to pay."

http://www.ft.com/cms/s/0/9973c5b0-8a6d-11dd-a76a-0000779fd18c.html
http://www.ft.com/cms/s/0/676fecaa-8a5f-11dd-a76a-0000779fd18c.html?nclick_check=1

Yes, it's foolhardy of the Congress to rush this thing out without consulting other financial experts (besides Bernanke and Paulson). Yet it appears that's what they're going to do. They might announce they have a deal tomorrow.

[TXfemmom]

This is correct. Additionally, I was in my bank the other day, and my banker, who happens to be along-time personal friend, said that there is talk within the banking community that UBS and other foreign banks are shifting their good assets out of the country to transfer them to their foreign mother institutions so all they have here is the crap. NO BAILOUT FOR FOREIGN BANKS.

Protect their depositors, assist in preventing foreclosures, and go after those foreign assets which were transferred, put their people in JAIL.

[faith]

Right ! The analogy of the Patriot Act and this $700 billion dollar nonsense is on point. Paulson is full of it - so are his republican counterparts.

[Brokenduck]

How exactly can any of these proposals control inflation? Unemployment or underemployment? I have been under the impression that most of the fundamentals of the economy have been weak for a long time now. How can this change the fact that incomes have been falling for nearly all Americans and that one could make the case that in the Bush years, the only thing that kept the economy from going into free fall was the housing bubble itself?

How far must housing prices come down? Were they not already too high? It seems that the toxic paper we are about to buy is toxic for a reason. Will houses again be used as ATM machines? Is it more important that we prop a failed system or that we seem to prolong the time of reckoning for a complete correction?

[oicnow]

Not only should the crooks that got us into this mess not receive any compensation, they should go to jail. This problem has been festering for over a year, so why suddenly is the White House pressuring us to fork over $700 Billion in just one week? This is nothing but extortion, a Money Grab by Wall Street tycoons while the Republicans still control the White House. It's Welfare for Billionaires. If you want to help individual homeowners refinance their mortgage, fine. But no giveaway to billionaires who are trying to rob the taxpayers. That $700 Billion could pay for health care, highways, green energy, and more. Don't throw it away on rich people who don't need it.

[SqueakyCat]

It is outrageous that other approaches are not being proposed and considered. There are many ways to resolve the current situation that make far more sense and cost pennies on the Paulson dollar.

The fundamental problem is that the value of mortgage backed securities are unknown which makes financial institutions hesitant to trust another.

The solution is to get an acceptable valuation of those assets and that does not cost $700 billion.

That effort can be augmented by efforts to prevent mortgage defaults which can be handled directly by the companies holding the mortgages perhaps with some federal assistance and incentives. Companies are already doing this because there is a major incentive in that each foreclosure costs $60,000 on average.

[ernestfromarnold]

How do you steal $700 Billion? You just ask for it! That's what's going on here. The Administration is seeking a pay day for themselves and their Wall Street supporters!

Do you remember the closing days of 2000 when Bill Clinton was pardoning his friends while Hillary was packing up White House Furniture? That was nothing compared to what's being attempted by President Bush. This is "Ocean's 14," "The Heist II," and "The Great Train Robbery" all rolled up into one.

[Jon Raymond - Huffpost Blogger]

Suppose I, as a borrower, decide I want to sell my debt to someone else so that I don't have to worry about paying it back, leaving me free to run up more debt? I'll sell it to a secondary borrower who will of course get a new lower interest rate at lower monthly payments. Makes perfect sense to me. Maybe we should try this with homeowners in trouble. Create a new secondary borrowing market. Call it trickle-you economics.

Now the government wants to force everyone to pay for these failed secondary market loans. If anyone should pay for this it's the primary and secondary lenders who caused the problem,. It's wrong to tax the people for this. What we should do is tax the failed companies. Have the IRS give them a nice long-term loan, like a mortgage, so that they can take their time to pay it off.

[kj11]

Thanks Mr. Kuttner.

The Bush administration and the Senate Banking Committee should have begun refinancing mortgages, from the bottom up, a year ago.

This top-down plan is emblematic of the top-down thinking of King George and his Cronies. Who cares about the peasants who are being foreclosed upon at the rate of 9,000 per day? They knew this was coming!

Predatory loans were made to many innocent homebuyers either first time or through refinancing. We know about the fraudulent practices of companies like Countrywide. These lenders and speculators and investment bankers should be investigated for criminal wrong-doing.

Chris Dodd and Barney Frank are not going far enough for the people. A reform of bankruptcy laws would enable homeowners to stay in their homes.

This is disgusting!

[planetjeffy]

Your idea would only cost us 325 billion right now. Suppose 3/4 can refi and pay out over 20 years. Then this would cost us 75 billion, probably less. But you are right, they should have been all over this for the last 2 years. It would have cost nothing. This is a cash grab by Bush and his buddies.

[McNuts]

I too question whether there is a crisis. It almost seems like a huge distraction while the Repubs go about cleansing the voter rolls of dems and setting up the vote rigging in the few swing states.

[McNuts]

Kucinich has written a compelling essay on the bailout and how it should be structured.

[JNo]

It's called "Disaster Capitalism". Ask Naomi Klein

[progressiveorlando]

This is a bit off point, but let me take this opportunity to congratulate you, Mr. Kuttner, on your performance on Hannity and Colmes a bit ago. I'm referring to when you suggested that the economy might not be in the best of shape and Sean Hannity took exception. I'm wondering if he's contacted you since to say that you were right after all. (That was rhetorical­.)

Keep doing what you're doing. You're a good writer, a better thinker, and -- if you don't mind my saying so -- a genuinely entertaining debater!