U.S. Treasury Secretary Henry Paulson lost his game of chicken with Congress yesterday. Despite warnings from Federal Reserve Chairman Ben Bernanke, the Congressional Budget Office, and President George W. Bush, the U.S. House of Representatives narrowly rejected a much-altered $700-billion proposal that would have given Treasury wide latitude to purchase toxic mortgage-backed securities with the intention of unclogging the credit markets.

Even as the Dow Industrial Average and other indices plunged, Congressional leaders could not save the bill. The Dow eventually settled at 10365.45, down 777.68 points or nearly seven percent from 1143.1 on September 26. The NASDAQ declined 9.1 percent to 1983.73; the S&P 500 swooned 8.8 percent to 1106.42.

The pressing question: Will Congress and the administration try to rework the proposal, or come up with something more palatable? Because, clearly, despite the addition of oversight, limits on CEO compensation, and taxpayer protection, opponents in the House were overwhelmed by the fear of facing voters in November.

Given the proposal’s defeat there may be other options worth Congressional consideration. Timothy A. Canova, associate dean and professor of international economic law at Chapman University School of Law, argues that the plan did not address the credit or the commercial paper markets. “The ban on short selling put a lid on that activity,” he contends. “The Federal Reserve should go out and purchase commercial paper. There’s a precedent for that.” The Paulson proposal would “not be very effective, because it basically would be digging from the top of the pyramid while the bottom continues to sink.” Canova warns that another wave of foreclosures is on the way, and criticizes the vetting process accompanying the Paulson proposal: “It’s shocking how limited the advice was in developing the bailout. Treasury listened to the same circle of advisors that got us into that rat-hole in the first place.”

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