What Comes After Senate Approval of the Bailout Bill?

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By Robert Kuttner

Congressional leaders need to look to more than just passing the bill in the House.

With the Senate’s passage of the bailout bill, 74 to 25, Democrats in Congress need to begin preparing right now for a second package to do the job properly. They also need to begin the tightest possible monitoring of Secretary Paulson’s actions and their effects on financial markets. Here is what is likely to unfold over the next few weeks:
The House will pass the bill after at least twenty more Republicans agree to support it. A few more Blue Dog Democrats may switch their votes to no, in protest against the trillion dollars of tax breaks added by the Senate as sweeteners for Republicans.

But Speaker Nancy Pelosi is now under severe pressure to deliver at least the 140 Democrats that she produced on the last vote, which failed because only 66 Republicans voted aye. If the measure were to fail again, this time because of Democratic defections, the Democrats would get the blame for the deepening financial carnage.

After the bill passes, we will see short-lived euphoria. The stock market will rally, and credit will begin to unlock. The overnight borrowing rate between banks will temporarily drop. But, after a week or two, as Paulson begins using his authority to buy up bad paper, the bloom will be off the rose—because there still so many unexploded grenades in the financial system.

Hedge funds will likely be the next casualty, as investors begin withdrawing large sums of money and the funds need to sell assets at depressed prices. Hedge funds typically prohibit their investors from withdrawing funds for a set period, called a lock-in, often two years. This allows hedge funds to pursue highly speculative strategies, knowing that their investors won’t sell out when times get rough. By coincidence, the lock-in period for many hedge fund investors begins expiring this week.

It will also be clear that relieving banks of bad mortgage-backed bonds is not solving the underlying foreclosure crisis. And even if the Securities and Exchange Commission uses its new authority to suspend “mark-to-market” accounting rules, so that banks do not have to downgrade the value of the junk still on their books, it won’t change the underlying reality that banks have taken huge losses and are now severely undercapitalized.

So what should the congressional leadership do?

First, prepare for the likelihood that Congress will have to act again, possibly before the election, almost surely before next January. Hold hearings with expert witnesses on the alternatives to the Paulson plan. The two most important ingredients of a better plan are direct government refinancing of distressed mortgages, and direct government equity investment in troubled banks with government either taking full control of getting a major ownership share.

Second, the House should, at the very least, add to the bailout bill even tighter monitoring requirements. Failing that, Congress should keep Paulson on a very tight leash, so that he blows through as little of the $700 billion as possible on a strategy that can’t work.

Congress should prepare, in detail, to rescue the rescue. The need could materialize either before or after November, but it will surely land squarely on the desk of the next president. And since that president is increasingly likely to be Barack Obama, he and the Democrats need to begin preparing yesterday.