September 26, 2008 10:16 AM

The Bailout Comes to Alice in Wonderland

As only the most cynical pundits predicted, now Democratic congressional leaders have managed to ally themselves with the unpopular out of touch President Bush, while House Republicans sound populist notes.

Those same House Republicans are floating a proposal to address the crisis by cutting capital gains taxes. Really.

While Democratic leaders announce that they are willing to cave on allowing bankruptcy judges the right to restructure mortgages for those who have been foreclosed and forced from their homes. Again, really.

Some readers of my commentaries have wondered whether our opposition to the rescue bill means that there are not serious cracks in the financial system. Not at all. They are very serious. What is concerning to us is that the Administration has simultaneously proposed a solution that on the merits is not very good (more on that in a moment), ignored existing serious problems with obvious solutions, and left themselves plenty of room to enrich their friends.

Lots of alternative solutions have been batted around for a spare $700 billion - any of the following have some merit - specifically, more merit than the Administration plan:

1. inject $100 billion into the FDIC reserves to prevent loss of depositor confidence;
2. support the Federal Reserve in its injection of capital into ailing firms, such as AIG (did anyone know that the Fed could take equity stakes in financial companies until two weeks ago? Targeted equity investments in at risk firms, at market prices, are far better than the purchase of toxic debt.
3. immediately apply capital requirements to credit default swaps.

The underlying economic problem is that the value of housing in the United States has fallen dramatically. It has not ceased falling, either. Since real mortages are now defaulting, and foolish Wall Street mavens created synthetic securities they did not understand but profited from free of disclosure or regulation, Wall Street has magnified the underlying real economic problem. It is realistic to expect a major contraction that simply reflects real economic losses. This cannot be papered over.