I grudgingly conclude that something needs to be done to resolve the credit crisis.  Like most people, I have been struggling to get to the truth.  After reading several articles, I agree the economy could indeed freeze if businesses cannot get the short term loans they need to keep running.

The most reprehensible aspect of the credit crisis is that it is self-inflicted.  As The New York Times columnist Thomas Friedman stated on September 30, 2008:

I’ve been frightened for my country only a few times in my life: In 1962, when, even as a boy of 9, I followed the tension of the Cuban missile crisis; in 1963, with the assassination of J.F.K.; on Sept. 11, 2001; and on Monday, when the House Republicans brought down the bipartisan rescue package.

But this moment is the scariest of all for me because the previous three were all driven by real or potential attacks on the U.S. system by outsiders. This time, we are doing it to ourselves. This time, it’s our own failure to regulate our own financial system and to legislate the proper remedy that is doing us in.

Last night (Oct. 1, 2008), the Senate passed a $700 billion bailout bill.  According this CNN article, the provisions of the bill are:

1. “The core is the Treasury’s proposal to let financial institutions sell to the government their troubled assets, mostly mortgage-related. … Treasury access to the $700 billion [is allowed] in stages, with $250 billion being made available immediately.”

2. There are a “number of provisions that supporters say would protect taxpayers. One would direct the president to propose a bill requiring the financial industry to reimburse taxpayers for any net losses from the program after five years. And the Treasury would be allowed to take ownership stakes in participating companies.”

3. “[A] stipulation that the Treasury set up an insurance program – to be funded with risk-based premiums paid by the industry – to guarantee companies’ troubled assets, including mortgage-backed securities, purchased before March 14, 2008.”

4. “It would place curbs on executive pay for companies selling assets or buying insurance from Uncle Sam. One provision: Any bonus or incentive paid to a senior executive officer for targets met would have to be repaid if it’s later proven that earnings or profit statements were inaccurate.”

5. “Two oversight committees. A Financial Stability Board would include the Federal Reserve chairman, the Securities and Exchange Commission chairman, the Federal Home Finance Agency director, the Housing and Urban Development secretary and the Treasury secretary.”

6. A temporary raise in “the FDIC insurance cap to $250,000 from $100,000. It says the FDIC may not charge member banks more to cover the increase in coverage.  Instead, the bill allows the FDIC to borrow from the Treasury to cover any losses that might occur as a result of the higher insurance limit.”

7. “It would extend a number of renewable energy tax breaks for individuals and businesses, including a deduction for the purchase of solar panels.”

8. “The Senate bill would also continue a host of other expiring tax breaks. Among them: the research and development credit for businesses and the credit that allows individuals to deduct state and local sales taxes on their federal returns.”

9. The bill “includes relief for another year from the Alternative Minimum Tax, without which millions of Americans would have to pay the so-called “income tax for the wealthy.”

In the rush to pass this bill, I have grave concerns that other cheaper and better alternatives have not been explored.  An interesting alternative solution has been proposed by Steven Wallman, who was an Securities and Exchange Commissioner under President Clinton.  Here is summary of his take:

… Bottom line, it’s a proposal [the Senate’s proposal] that could work. But it’s not the best.

Instead, thinking folks might say why not solve the underlying problem – the cause – not the symptom? The root cause of the crisis, simply put, is homeowners’ mortgage delinquencies and foreclosures. When the mortgages backing securities suffer, those mortgage-backed securities suffer, and so do the banks holding them. But, if the government buys the mortgage-backed securities, that does nothing – absolutely nothing – to make the underlying mortgages more valuable or more likely to be paid, stabilize home prices or help homeowners in distress. It does nothing – absolutely nothing – to directly benefit the real economy.

But another proposal does. Use the $700 billion on the table and stabilize housing. Make that money (actually only a fraction would be needed) available to homeowners who live in their homes (not speculators). Here’s how: Offer any financial institution (or require it, although no financial institution in its right mind would refuse the offer anyway), that owns a mortgage of an owner-occupied home in distress, to provide that homeowner, in lieu of any penalties or foreclosure, a government guarantee of the current or missed payments under the mortgage. If the homeowner agrees to have the government take over the payments, the financial institution would inform the government, the government would make the payments, and the homeowner in exchange would sign a note agreeing to repay the government some years in the future (say, 10), with interest at the same rate currently required under the homeowner’s mortgage.

A few observations: First, the process is simple; it could be implemented without huge new government programs. It relies on regulated and monitored entities who know how to process these transactions, and there is no sudden time pressure to buy billions of dollars of anything over the course of a few weeks…

Wallman concludes his solution with:

On the downside, in the event the home never appreciates enough to pay off the government note (which will be paying off the primary mortgage), then the taxpayers may lose some value if the homeowner does not step up (but not a loss anything like what’s being proposed now) and there is a lot of time to allow the economy and its home-owning citizens to recover. The government will have years to determine if it wants to extend payment schedules, or take other actions to mitigate any issues.

Overall, this is a simple proposal that actually works. No one is bailed out, although the government accepts some risk. The system re-lubricates and the global economy is saved. Little money is actually needed to implement this, and if the economy recovers quickly enough with this proposal in place, home values may stabilize enough for conventional refinancing to work, so the government would actually pay very little. There is a win for everyone in this – if only you can get past the politics.

The other problem I have with the Senate’s proposal is its inclusion of unrelated issues. While I support tax breaks for renewable energy and relief from the Alternative Minimum Tax, these provisions do not belong in this bill and should be considered as separate bills.

The Senate’s proposal is packed with pork. We need a fast, thorough, and comprehensive discussion to find a solution that minimizes taxpayer risk.  We need tough laws and regulations to prevent another self-inflicted wound.  This wound is critical.  The next one might be fatal.