Is The Bailout Broken?

Apparently, House Republicans are in open revolt against the Wall Street bailout plan put forth by the White House and Treasury Secretary Henry Paulson. Part of it may have to do with all the changes that the Democrats made to the plan to make it palatable to their constituents, like allocating 20% of profits made by the US Treasury on the deal to a program to help low-income folks keep their homes.

As the AP reports ...

A White House summit meeting on Thursday meant to shore up John McCain's shaky campaign "devolved into a contentious shouting match." And that's how McCain's own campaign described it.

The meeting revealed that President Bush's $700 billion bid to combat the worst financial crisis in decades had been suddenly sidetracked by fellow Republicans in the House, who refused to embrace a plan that appeared close to acceptance by the Senate and most House Democrats.

By midnight, it was hard to tell who had suffered a worse evening, Bush or McCain. McCain, eager to shore up his image as a leader who rises above partisanship, was undercut by a fierce political squabble within his own party's ranks.

The consequences could be worse for Bush, and for millions of Americans if the impasse sends financial markets tumbling, as some officials fear. Closed-door negotiations were to resume Friday, but it was unclear whether House Republicans would attend.

And this next part is very dramatic, and should make for a good scene when this fiasco is inevitably turned into a TV mini-series ...

Treasury Secretary Henry Paulson literally bent down on one knee as he pleaded with House Speaker Nancy Pelosi not to withdraw her party's support for the package over what Pelosi derided as a Republican betrayal, according to the New York Times.

Not all Republicans in the House are opposing the plan, but the conservative wing, led by House Republican leader John Boehner of Ohio, wants to take a different route, founded on more "conservative" principles.

Wait, it gets better! The New York Times reports that McCain sat silently at the meeting he'd called for about 40 minutes. So, Obama tried playing mediator. Again, witnesses report that Obama first tried to reason with Boehner, and asked him to detail what his plan was. According to witnesses at the meeting, Boehner put forth (somewhat heatedly) the right wing plan: deregulation, capital gains tax cuts, and an insurance plan. The new House Republican plan would have banks, financial firms and other investors that hold such loans pay the Treasury to insure them.

After he did this, Obama asked Paulson if it would work, and Paulson said that it would NOT work (which was why house Republicans didn't ask him about this at the meeting yesterday).

According to AP ...

Then Obama said it was time to hear from McCain. According to a Republican who was there, "all he said was, 'I support the principles that House Republicans are fighting for.'"

And that, say witnesses, is when the shouting started.

Now, Treasury Secretary Paulson has called the House Republicans' plan a non-starter. So where does this leave us? Maybe we'll go with a plan designed by the Democrats, like the one proposed by James Galbraith. Writing in the Washington Post, he said the bailout as proposed was "A Bailout We Don't Need," and added ...

Now that all five big investment banks -- Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs and Morgan Stanley -- have disappeared or morphed into regular banks, a question arises.

Is this bailout still necessary?

The point of the bailout is to buy assets that are illiquid but not worthless. But regular banks hold assets like that all the time. They're called "loans."

With banks, runs occur only when depositors panic, because they fear the loan book is bad. Deposit insurance takes care of that. So why not eliminate the pointless $100,000 cap on federal deposit insurance and go take inventory? If a bank is solvent, money market funds would flow in, eliminating the need to insure those separately. If it isn't, the FDIC has the bridge bank facility to take care of that.

Next, put half a trillion dollars into the Federal Deposit Insurance Corp. fund -- a cosmetic gesture -- and as much money into that agency and the FBI as is needed for examiners, auditors and investigators. Keep $200 billion or more in reserve, so the Treasury can recapitalize banks by buying preferred shares if necessary -- as Warren Buffett did this week with Goldman Sachs. Review the situation in three months, when Congress comes back. Hedge funds should be left on their own. You can't save everyone, and those investors aren't poor.

The rest of Galbraith's plan is investment in infrastructure and renewable energy to help pull us out of what he sees as an inevitable coming recession.

Now, I'm happy to see Paulson's plan, as proposed, go away. I'd be happier with other alternatives that have been proposed -- Galbraith's plan for example -- that probably have a better chance of success.

But we can't forget that the reason that Paulson, Bernanke and other leaders in Washington were so keen on their plan in the first place -- they are terrified of what comes next if some kind of bailout isn't passed.

What the Democrats are really trying to get is a bailout of Main Street, not Wall Street. Without credit, Main Street cannot function. Without it, as one observer said, "we are possibly looking at Great Depression II, and the sequel is always worse than the original."

What does this mean for investors?

If there is no bailout deal, it's probably bad for oil prices. It's certainly bad for stock prices, especially financial stocks. Industrial materials and industrial stocks are also going down. Short-term Treasuries and the yen will probably rally hard, as investors fly to safety.

That said, I still think we'll see some kind of deal over the weekend. There is too much at stake. If Paulson's plan is dead, and if the House Republican plan is a non-starter, maybe they'll go back to square one and start with a Democratic plan. We may not like a Democratic plan ... and it may not fix the problem either. But if we have a plan on Monday, oil will probably head higher, and we'll probably have a strong market rally.

I hate the fact that we have to rush into this. I'd like some careful deliberation ... a real attempt to find out what the problems are and find workable solutions. I hope we get the time we need.

We'll see. It should be an interesting day.

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