Why Did Paulson’s Bailout Plan Fail in Congress?

“OK, everyone, stay calm. Hand over the $700 billion right now, and no one gets hurt. Make a wrong move, and the whole economy goes down! Make it quick, or you can all kiss your retirements good-bye!”

Dialog from an old-fashioned “stick-em-up” Western? No, actually, this drama was playing out in real-time Congress last week as Treasury Secretary Hank Paulson, Federal Reserve Chairman Ben Bernanke, and President George W. Bush promoted a $700 billion financial bailout plan to Congress and, I might add, a mob of very angry constituents. The drama ended today with the House of Representatives voting to reject the plan.

Paulson’s bailout plan has forced Main Street and Wall Street into a really ugly confrontation, and if you think I’m overstating this, read the comment sections attached to the New York Times editorials. Those comments are running at around a thousand or more each day. Wading through them, I found not one that said anything remotely resembling, “Thanks Hank! What a great idea! Thank goodness we have a smart guy like you in charge at a terrible scary time like this!”

Before rejecting it, Congress had managed to negotiate some governmental oversight to be added to the plan (the original bailout deal specified no oversight allowed and complete immunity from prosecution) and also negotiated the addition of some provisions for helping homeowners in foreclosure refinance and stay in their homes. Still at issue were CEO salaries and consequences for banks and lending institutions that avail themselves of the Paulson plan to buy up the worst junk on their books: mostly dubious and impossible-to-value mortgage-backed securities, credit default swaps, and other weird, overly creative investment vehicles that threaten to bring the U.S. economy to a catastrophic halt.

What was emerging, as Paulson’s request sunk in, was an incredible amount of public outrage. Initially, the request was for Congress to push the bailout plan through in a day, if not sooner, or suffer dire consequences. It didn’t take long for the American public to start calling their representatives nonstop to let them know that they would, personally, rather suffer dire consequences than hand over $700 billion in taxpayer money to a Wall Street investment banker on the strength of two words: “Trust me.”

Putting dire warnings and assurances of fiduciary responsibility aside, there was no guarantee that this plan (which was literally cobbled together overnight) would work. Comparisons have been made between Paulson’s plan, or, as NYT columnist and Princeton economist Paul Krugman calls it, the “Cash for Trash” plan, and the Resolution Trust Corporation of 1989. The RTC took home mortgages seized during the savings and loan crisis of the late 1980s and sold the homes attached to those mortgages, eventually recouping some of the money lost in the S&L failures. The markets stabilized, and the RTC was widely credited for helping to get the economy back on track.

The original RTC took in $225 billion worth of bad assets and sold them for $140 billion over time, reducing the actual taxpayer cost of that bailout to around $85 billion. But the Paulson plan was widely expected to top $1 trillion for the initial purchases, and there is a big difference between the assets seized then, which were backed by real property, and the assets clogging the books today, which are so complex and poorly constructed that decoding what backs them and where that property might be has become a nightmare in its own right.

No one knows the actual value of these assets, or if they even are assets, and whether they will ever have any resale value. If they are purchased too cheaply, banks will have to declare large losses and may fail anyway. If they are purchased at too great a cost, it amounts to handing over taxpayer money to the very institutions that created the problems in the first place.

Acknowledging the difficulty in valuing and purchasing these junky securities, Paulson’s solution was to hire investment analysts from the private sector to broker the deals and to protect the brokers and the buyers under a cloak of immunity from scrutiny and prosecution. The appeal of such an approach for Wall Street is obvious. On September 19, stocks rebounded insanely, causing even sympathetic investors (the few that remained) to recoil in disgust. But what was the appeal to taxpayers?

The appeal was, “This will stop The Great Depression II from happening.”

Whether it will or won’t, Congress has killed the chance to find out. For now.

10 comments to Why Did Paulson’s Bailout Plan Fail in Congress?

  • [...] especially since many have contributed to the present crisis by taking too many risks. There were calls to impose some limits or approval authority on salaries of executives whose firms seek [...]

  • Thank you for your useful insight into why Paulson’s bailout plan was voted down in the House of Representatives. It really helped to shed some light on the faults of this $700 billion piece of legislation With the market’s record-setting drop after this news was released, I think many people are wondering why exactly Congress voted against this plan and, had it been passed, whether the economy would have taken the downturn it had on Monday. Your analogy of the lobbying for this plan to an old western film is depressingly fitting, as Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke seem to be convinced that the only way to turn our economy around is by taking money out of the hands of the public and into the hands of the people who started this crisis in the first place.

    I liked how you used the comments on New York Times editorials as evidence of a confrontation between Main Street and Wall Street. It adds a tangible aspect to a claim that is otherwise hard to quantify. I also liked your analysis of the analogy between this bailout plan and the Resolution Trust Corporation of 1989. I have seen the link made between the two before, especially in the context of the bailout not costing taxpayers as much as initially thought, but did not know enough about the Resolution Trust Corporation to be able to make the comparison. I agree that the comparison is not valid, for the RTC bought and sold actual assets, while this proposed bailout plan would be buying faulty financial instruments, the mortgage-backed securities.

    Though I thought your blog was well researched and informative, I have some questions and comments about it. First, do you think the only reasons for the public outrage were CEO salaries? I don’t see any other reasons in the article other than the lack of a guarantee that the plan would work. Also, while you say that Congress negotiated some governmental oversight and provisions for helping homeowners keep their homes, I think this article would have benefitted by explaining those changes in more detail. The current description is relatively vague.

    Thanks again for the helpful insight and I am looking forward to continuing reading your blog as the financial crisis progresses.

  • Hi Kirk,

    Thank you for your comments and questions. In answer to your suggestion about the details of the blog, I actually wrote this blog before the vote, and it was then edited it to make sense once the bill failed. Things happened so fast that it was tough writing about them as fast as they were happening! Not just here at Amateur Economists but everywhere. When I wrote this the amendments were still being negotiated.

    Anyway, in the future I will certainly give more attention to specific clauses should Congress be able to write another similar bill. I don’t think the CEO salaries were the only objection the public had to this one–I think that it was a more general revulsion at the idea of handing so much taxpayer money over to the very industry that has caused the economy so much damage and that caused this problem in the first place.

    I also think there was a lot of distrust of the Bush administration and the Treasury Secretary. Hank Paulson used to be a CEO at Goldman Saks, and I know many people saw this as an attempt by Wall Street to “cash out” before the economy tanked completely. Last but by no means least, I think Paulson and Congress did a very poor job of explaining what it was they were doing and why ordinary people should care about it. The term “credit markets” means nothing to most people. People hear the term”credit” during a financial meltdown and they think, “Well, we should stop using credit anyway.” The core issue wasn’t explained very well at all.

    Thank you for your thoughtful post and all the best to you. Now that this first bill has failed, it will be interesting to see what, if anything, happens next.

  • Stephan Zimmermann

    There are many reasons for the failed House bailout bill.

    Executive compensation is just one. Hundreds of millions of dollars in pay or bonuses or golden parachutes simply seem excessive to many of the folks in what is now euphemistically called “Main Street.”

    When it comes to those firms “bailed out” by the federal government, we certainly couldn’t agree more. After all, he (or she) who has the money makes the rules.

    Unfortunately, too many potential voters fail to see the greater philosophical implications of the bailout in the first place. Do we really want a “free market” or do we feel more comfortable with a higher degree of socialism?

    Of course, the timing could not have been more unfortunate, coming at the tail end of a national political season. The campaign already pointed out the very essence of the difference between what passes for capitalism and government paternalism.

    The rush by members of both major parties to a federal bailout was reminiscent of the immediate support for the legislation following the sad events of 2001. That panicky legislation, with its blank check attached, resulted in another long, drawn-out war, which the United States cannot and should not have to afford.

    If CEO compensation was a key sticking point of the failed bill, as House Speaker Nancy Pelosi suggested before the bill’s vote, the vague language of the rest of the bill could not provide any comfort to the plethora of lawyers represented in Congress.

    Especially noteworthy was the phrase “unnecessary and excessive risk.”

    How should “risk” be defined? Who is to judge and set the limits?

    Maybe it’s old-fashioned, but banks should be safe, not given to undue risk. An invetment house, on the other hand, is purely in the business of risk.

    Protecting people’s savings during the S&L crisis seemed prudent. Bailing out banks and investment bank does not.

    Depositors from “Main Street” are already protected by FDIC or the courts, as in the various settlements with
    Credit Suisse, UBS and many others.

    Massive regulation of the investment and banking world might simply shift investment to venues more friendly.

    Switzerland, with its centuries-old banking business, makes clear its regulations out the outset. Even better, the chief executive in charge of a bank faces going to jail even if he/she was not personally responsible for any personal wrong-doing!

    That model might serve as a poignant example to Wall Street and Congress.

  • It failed because our imperfect representative democracy when pushed to the limit, and backed into a corner works. 60-65% of Americans were vehemently opposed to this, only 20-25% supported it, and the rest were undecided. Calls to representatives offices were 100:1 against. The entire House of Representatives is up for re-election in 35 days (as opposed to the Senate where it is only 1/3). This bill was political suicide.

    Throw in the fact that there was a petition signed by 200+ economists, some Nobel laureates, some from MIT and Harvard stating that his was bad for the economy and the only question I have is how it got to a full vote in the first place and how it was so close???

    Great stats on the RTC losses, you don’t hear those everyday from the MSM.

    I am saddened that the Senate is trying to make a go of it now. I keep thinking don’t double jeopardy rules apply??? j/k

    Do note that while the DJIA fell 500 points after the bill was defeated (I know it closed down 777 but it was already down about 280 prior to the vote) oil fell by $10/barrel, the dollar rallied, and treasury yields which make up long term interest rates fell 0.2%.

  • Hi Stephan & Josh,

    Thank you for your thoughts on this. It certainly is hard to make a clear case to the American people that this bill is necessary when the DJIA is up 300 points, down 700, then up 400 again in the course of only a few days. That’s what people see: the stock market. Credit markets are less visible, and its easy to come to a conclusion along the lines of , “Well, credit got us into this mess, credit should be tighter, that’s a good thing.”

    The problem is, if confidence isn’t restored to the point that banks at least lend to each other and to businesses on a day to day basis, then some businesses will fail, consumer purchases will fall off even more sharply, and the downward spiral will speed up significantly. That is harder to sell to the public, and no one likes to be told that “it’s all too complicated for ordinary people to understand.”

    I think that underlying much of the outcry against the bill is a total lack of trust in our leadership and Wall Street, and also a belief that we are in for tough times no matter what the government does. It will be interesting to see how the Senate vote goes.

    Reminds me of the supposed Chinese curse:

    “May you live in interesting times.”

  • [...] à Wall Street était importante pour les américains. Apprenant avec consternation que le « plan Paulson » de 700 milliards de dollars n’avait pas été approuvé par le Congrès malgré les appels au [...]

  • [...] the wrangling in Washington over the current banking crisis reminded me of that debate. The holidays are approaching, lots of [...]

  • [...] been engaged in a few political actions involving tax payer risks – asking Congress to approve Treasury Secretary Hank Paulson’s $700 billion bailout plan, agreeing to lend $85 billion to American International Group, taking on $30 billion in illiquid [...]

  • [...] from the banks and financial institutions for the bailout packages, the government could swing the public opinion in its favor. Using taxpayer’s money for bailing out large corporations without offering anything [...]

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