Nils Pratley

It was a bad plan — but it was a plan. The refusal of the US House of Representatives to back Hank Paulson’s bail-out takes us into new territory. George Bush told Americans to expect “a serious financial crisis” and “a long and painful recession” if the legislation was blocked. Paulson went down on his knees to beg for support. But opposition from ordinary Americans killed the bill.

It was a historic day: even the decimal point on the Dow Jones average made it memorable. The final reading was: down 777.7 points. Some horsetrading in Washington may yet produce a revised deal that would be acceptable to the politicians, but the banks know there will be no handouts: Main Street wants to see Wall Street suffer. In election year, voters get what they want.

The immediate challenge for the central banks is simply to keep the banking system functioning — ensuring that payments are processed and that companies can continue to pay everyday bills, such as wages. The Federal Reserve will flood the market with emergency funds. The sums were already staggering. Before the vote in the House on Sept 29 the Fed released $620bn. The number may get bigger in the next few days. It’s a case of using “all tools available”, as the Treasury put it. These could also include emergency cuts in interest rates, as we saw after 9/11.

Even so, more bank collapses and takeovers look almost inevitable. Money is flowing towards perceived safe havens at alarming speed. Ever since Paulson announced his plan ten days ago, two of the biggest US commercial banks have been taken over and their shareholders wiped out; in the UK Bradford & Bingley bank has been nationalised; Fortis, Belgium’s biggest bank, has been partly nationalised; and the crisis has spread into major institutions in Germany and Iceland. All that happened while the Paulson plan looked likely to be passed.

In Washington politicians, if they are serious about finding a new bail-out model, will have to recognise the reasons why the last one failed. Paulson and Bush misjudged the mood of the US. Paulson asked for authority to spend $700bn with no outside scrutiny, and offered Congress few details on how the cash would be spent. What prices would the treasury pay? Paulson couldn’t say. His original proposal ran to just three pages. Bush’s address to the nation lasted only 12 minutes. The voters saw arrogance. What form would a revised bill take? There would clearly have to be greater scrutiny of the Treasury’s operation and tougher curbs on executive pay. But the markets will be concerned that the size of the bail-out will also be reduced.

So a revised plan might mean offering capital to banks. That might involve the US government taking stakes in financial institutions to protect taxpayers. Citigroup, in buying Wachovia yesterday, agreed to give $12bn of preference shares to the banking regulator as part of loss-sharing. But the painful fact is that legislation can’t be passed overnight; that leaves financial markets time to panic.