HOUSE DEFEATS PAULSON BAILOUT

In what media pundits called a "great surprise", the U.S. House of Representatives defeated, by a substantial margin, proposed legislation that would have granted the Treasury Secretary of the United States unprecedented authority to buy securities and debt in the open market in an effort to prevent continued deterioration in the value of these assets.

Although he didn't participate in the vote, presidential candidate and U.S. Senator John McCain stated in a brief post-vote news conference that legislators from both houses would have to go "back to the drawing board" to fashion a new plan, which seems to imply that the Paulson Plan is dead. In the mean time, the stock market reacted violently; financial stocks lost 13% but ended the day 10% above the lows posted in July, which implies that they could have much further to fall.

Also in the news today the FDIC put down another massive bank, North Carolina-based Wachovia (formed by the merger of First Union and Philly-based Corestates banks), and fed it to Citigroup, only days after they had euthanized Washington Mutual and fed it to JP Morgan, and folded Merrill Lynch into Bank of America (for some reason, Lehman Brothers was left to the bankruptcy courts to sort out). At the moment there appears to a consortium of five banks that the Federal Reserve is utilizing as the repository for the deposits of competitor banks that become functionally insolvent: Goldman Sachs, JP Morgan, Citigroup, Bank of America, and Morgan Stanley. It appears that the Federal Reserve has decided that these banks must not fail, and is prepared to print as much money as it has to in order to keep them solvent. That could be expensive, especially if JP Morgan fails to sell enough stock to fund their capital base. In fact, the capital positions of all of these banks if far from certain, as a deep recession and increased defaults could push them into insolvency, in particular JP Morgan which is more highly leveraged. However, if you feel the need to buy the common stock of a U.S. bank, these five would be a good place to start looking.

So, what can the Congress do at this point to prevent another Hoover-era financial meltdown? Right now, without Congressional approval, the SEC can alter a rule that says that banks must price their mortage-backed paper and derivatives to market, rather than face value, increasing the book value of the banks that hold the paper; however, since the paper is highly illiquid (nobody wants to buy it off them), it does not really guarantee the solvency of the institution, and other institutions will still view these banks as vulnerable. In any event, a move such as this will buy the banks additional time and could forestall an FDIC take-over, which may be enough to allow the free market to find a solution without government intervention. Additionally, the FDIC can help assuage the fears of depositors over the security of their deposits, especially small businesses who have more than $100K of deposits in U.S. banks, by increasing the federal insurance amount to $250K.

Finally, Congress can focus on the segment of the economy that suffers the most from a dysfunctional credit market: small business. Small businesses, which are generally more lightly capitalized and usually cannot tap the equity markets for funding, are highly dependent upon short-term lines of credit to buy raw materials and make payroll. Congress can act quickly to allocate additional authorizations to the Small Business Administration so that it can secure loans to small businesses that cannot get the necessary capital from the commercial banks. With the SBA guarantee, the commercial banks will gladly extend the loans at reasonable terms, and small businesses can continue to operate.

So, the failure of the Paulson Plan, which would have allowed companies like his former employer, Goldman Sachs, to sell their toxic paper to the U.S. Treasury, and then buy it back at a later date at a discount, is a good thing, and kudos to the American public for having their voices heard.

Christian Antalics