Extortion Redux: Congress To Tweak Bailout or Risk Deep Recession

Congress to tweak bailout or risk deep recession
By David Lawder and Patrick Rucker | Reuters.com

U.S. efforts to revive a $700 billion bank bailout bill with some new provisions offered hope for battered markets on Tuesday, and economists warned of a long and deep recession if efforts to resuscitate it fail.

The defeat of the bill on Monday in the U.S. House of Representatives left two likely scenarios -- the plan gets tweaked enough to win passage, or Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke return to a limited tool box and piecemeal approach to dealing with the financial crisis.

A complete rewriting of the bill appears unlikely.

"For the near-term, we're going to get some modification on the Paulson plan and pass it or we're not going to get anything," said Michael Mussa, former chief economist at the International Monetary Fund.

"The worry is that if we don't pass the Paulson plan, we could have a steep recession that is among the worst we've seen in the post-War era," said Mussa, now a senior fellow at the Peterson Institute for International Economics in Washington.

The $700 billion financial rescue plan aimed to unfreeze credit markets by having the Treasury buy up problem assets that are plaguing bank balance sheets, stalling lending, and adding to fears that more institutions will fail.

The bill's spectacular rejection in a razor-thin vote on Monday spurred policy-makers and congressional leaders to try to persuade about a dozen Republican lawmakers who voted "no" to change their minds.

"It's going to take us a little bit of time to figure out where the possible votes are -- figure out what, we hope, small policy changes are necessary to attract those votes," White House economic adviser Keith Hennessey told Fox News Channel. "We're starting to do that."

One possible change that gained traction on Tuesday would lift the federal guarantee on bank deposits up to $250,000 from the $100,000. The Federal Deposit Insurance Corp formally asked for a temporary increase and presidential nominees John McCain and Barack Obama threw their support behind the proposal.

POWER VACUUM

The defeat of the bill was driven by a collection of Republicans and Democrats, many of whom face tight re-election races on November 4 and are getting angry calls and emails from constituents upset at the idea of bailing out Wall Street.

Many Americans see the bailout as an excessive burden to taxpayers and believe the money would reward Wall Street executives who should have been more careful with their money. They also are irked by the idea of helping people who took out larger home mortgage loans than they could afford. Rising mortgage defaults are at the root of the current crisis.

The bill's defeat underscored the absence of a strong hand in Washington, as neither lame-duck President George W. Bush, Democratic House Speaker Nancy Pelosi, or House Republican leader John Boehner were able to deliver the needed votes.

Paulson and Bernanke also were guarded in their pitch for the program, reluctant to say publicly that a severe recession could ensue if no action was taken. The result was a disconnect with "Main Street" America.

GETTING THE SWAY-ABLES

The key to winning enough "yea" votes could be to blend small policy changes with a hard pitch to the lawmakers who could support a rescue but find the current plan distasteful.

"I do understand that we do have a serious crisis that is not just going to go away," said Rep. Mario Diaz-Balart, who said he is open to backing a government rescue. But like many conservative lawmakers, the Republican from Miami is uneasy with the sweeping plan drafted by Paulson.

Diaz-Balart said he could envision voting for a bill if it offered more congressional oversight and saw Wall Street firms putting up capital. "They have to put skin in the game or blood on the table before the taxpayer should offer anything."

Lawmakers from Florida, California and the Southwest who represent constituents who have seen their home values plummet might also be open to plan that could ease housing finance pressures. A report on Tuesday showed house prices nationwide fell a 16.3 percent in the 12-months through July, the biggest drop on records dating back more than two decades.

Financial services lobbyists are also targeting the 10 House members from Ohio who voted "no" since the state is home to three large regional banks - Key Corp, Fifth Third Bancorp and National City Corp.

MARKET PLUNGE REDUX?

Monday's U.S. stock market sell-off, the largest-ever point decline, gave way to a partial recovery on Tuesday as investors bet that the bailout bill would be revived and passed later in the week. The Dow Jones industrial average closed up 485 points.

Aiding sentiment was a Reuters report that U.S. securities regulators would remind financial services firms that they don't need to use fire sale prices when valuing assets, a step they could take without passage of a bailout bill. After the market closed, they did just that.

But if a resurrected bailout plan fails to get Congressional approval again, markets will be in for another steep downturn, said Martin Regalia, chief economist at the U.S. Chamber of Commerce, which has been lobbying heavily for the bill.

"If we don't get this done, the recession we were already headed for will be deeper, longer in duration, and much more difficult to get out of," he said.

OTHER POLICY OPTIONS

Without the more-comprehensive approach that the bill would bring to combating the credit crisis, the Fed, Treasury and other agencies will have to stick to fighting brush fires one-by-one, flooding the banking system with liquidity and dealing with individual institutions as they teeter on the brink.

In the weeks leading up to Paulson's bailout proposal, he led the takeover of mortgage finance giants Fannie Mae and Freddie Mac, while helping to broker a decision to rescue insurer American International Group.

At the same time, the FDIC has successfully merged some troubled institutions, but this has not instilled confidence in financial markets. "If we're still in that mode, people are still going to be asking who's next," said Mussa.

The Fed could use its main weapon and cut interest rates to try to restore calm, but it would likely do little to aid the economy at a time banks are loathe to lend.

"You can always cut the fed funds rate, but so what if it doesn't affect the rate at which people borrow and banks lend to each other," said former Fed vice chairman Alice Rivlin, a senior fellow at the Brookings Institution.