Adrift and Afraid in Uncharted Territory

It was a bad plan - but it was a plan. The refusal of Congress 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 horse trading in Washington may yet produce a revised deal that would be acceptable to the politicians, but the banks know there will be no easy handouts: Main Street, for better or worse, wants to see Wall Street suffer. In an election year, voters get what they want.

What happens next? 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. The Fed yesterday - before the vote in Congress - 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 havens at alarming speed. Ever since Paulson announced his plan 10 days ago, two of the biggest US commercial banks have been taken over and their shareholders wiped out; Bradford & Bingley has been nationalized; Fortis, Belgium's biggest bank, has been partly nationalized; 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 some form.

In Washington politicians, if they are serious about finding a new bail-out model, will have to recognize 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, and no amount of muttering about "reverse auctions" could shift the perception that the taxpayer would be fleeced. 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.

Even before yesterday, $700bn had come to be seen in some quarters as too little. Worse, economists had started to question Paulson's approach to the problem. Many argued that buying distressed assets would not improve banks' basic problem that too little capital is supporting too much lending.

So a revised plan might mean offering capital to banks. In practice, that might involve the US government taking stakes in financial institutions as a means of protecting taxpayers. Indeed, it is already taking tentative steps in that direction. Citigroup, in buying Wachovia yesterday, agreed to give $12bn of preference shares to the banking regulator as part of a loss-sharing arrangement. That structure allows the US taxpayer to benefit if Citigroup makes a success of the purchase.

But the painful fact is that legislation can't be passed overnight. "Even if a new amended plan can be agreed, we doubt it will be in place until next week at the earliest," said Paul Ashworth, senior US economist at research group Capital Economics. That leaves financial markets time to panic.

In the UK the biggest worry is Lloyds TSB's plan to buy HBOS. The share prices are not behaving as if the deal is going to happen. HBOS has traded as much as 20% below the "see through" price - the price you'd expect to see if HBOS's shares were to convert into Lloyds stock. The bottom line is that the deal can only happen with the support of a Lloyds shareholders' vote. We found yesterday that you can't always rely on the voters.