No Bailout, Here's Plan B-

NEW YORK (CNNMoney) -- A day after the House's surprise defeat of a $700 billion financial rescue bill, talk is growing louder about alternative government steps that could help battered credit markets and stave off broader problems in the economy.

In fact, some of the things Washington could do could even provide more immediate relief than would the complicated proposal nixed by the House. The plan would have given the Treasury Department authority to buy as much as $700 billion in distressed mortgage-backed securities.

"Every little bit helps," said Lyle Gramley, a former Federal Reserve governor who is now with policy research firm Stanford Group. "When you're in a situation we're in now, you use any tools that might work."

Among the steps that the government could undertake are:

• Suspend so-called mark-to-market accounting rules, which during the past year have required financial firms to write down more than $500 billion in losses.
• Change federal requirements that force banks to keep a certain level of cash on hand for every dollar they lend out.
• Give banks the chance to exchange loan notes for notes from the Federal Deposit Insurance Corp. As a government agency, the FDIC's notes would be more valuable than the banks' notes, allowing the banks more flexibility to make loans.
• Purchase on a massive scale mortgage-backed securities issued by finance giants Fannie Mae and Freddie Mac. The Bush plan calls for the Treasury to buy a broader range of mortgage-backed securities.
• Extend limits on short sales of financial sector stocks.
• Cut the fed funds rate - the Federal Reserve's target for short-term lending - perhaps all the way to zero, or in coordination with rate cuts by other central banks around the globe.

In addition, there are other things Washington could do. On Tuesday, presidential candidates Barack Obama and John McCain both proposed raising the cap on bank deposits insured by the FDIC.

The current $100,000 limit has been unchanged since 1980 despite inflation. It protected as much as 82% of deposits in 1991, today it only covers 63%.

Raising the cap could stem a potential run on deposits by bank customers, particularly businesses, who fear losing their money. Such fears led to the collapse of Washington Mutual (WM, Fortune 500) and Wachovia Bank (WB, Fortune 500) in the past week.

Of course, all the proposals have their downsides and their critics.

For example, William Isaac, a former chairman of the FDIC blames much of the current credit crunch on the fact that the Securities and Exchange Commission is now requiring banks and Wall Street firms to value their mortgage backed securities at current market prices, rather than based upon the income they can produce over the life of the loans that back them.

"The SEC has destroyed about $500 billion of capital by their continued insistance that mortgage backed securities be valued at market value when there is no market," he said. "It's way below their economic value. And because banks essentially lend $10 for every dollar of capital they have, they've essentially destroyed $5 trillion in lending capacity."

But others argue that without those strict accounting rules for dealing with the value of mortgage backed securities, investors would be even more reluctant to invest in banks and Wall Street firms, making it even tougher for the to attract new capital.

"Does that make you less attractive as a public company? Absolutely," said Art Hogan, chief market analyst at Jefferies & Co.

Gramley also questions getting rid of mark-to-market accounting for the same reason. He would rather see the FDIC and other bank regulators relax its rules for the required ratio between capital and loans on the books. He said that's choking off credit to good customers. He said he knows of a businessman with perfect credit and a $20 million net worth who just had his bank reject his request to renew his $1.8 million business loan.

"The bank told him 'Our regulators are requiring us to improve our capital ratios, but we can't raise capital because the market is shot,'" Gramley said. And Gramley said the bank won't cut off the loans to those who have trouble paying the loans immediately because that would cause an increase in the number of loan defaults, so instead it is squeezing some of its best customers.

But Isaac argues changing the capital ratio requirements or easing other regulations would amount to regulatory forbearance and would only lead to deeper problems down the road. "That simply doesn't play well," he said.

No rush to try alternatives

It's unlikely that the Fed, Treasury or other government agencies authorized to take such steps would do so until Congress takes up the bailout proposal once again.

Brian Gardner, the Washington analyst for KBW, an investment firm specializing in financial services, said he believes Treasury and Fed officials believe they can keep more pressure on Congress to pass the rescue plan by not taking extra steps ahead of a final vote.

"The alternatives are good - I don't think they do any harm," Gardner said. "But none of them are as powerful as the rescue package would be. If the Congress doesn't move on something, they'll become more likely because the regulators will be forced to look at different solutions."

With the House in recess until Thursday, negotiations were taking place behind the scenes rather than on the floor of the chamber. The Senate is in session but not tackling the bailout on the floor.

Right now, it's unlikely that a new vote would take place before Thursday. Stocks rallied on Tuesday as investors believed that Congress will still approve the bill.

But credit markets stayed very tight. The Libor rate, the rate at which banks lend to one another, rose to 4.05% up from 3.88% Monday. Translation: Banks are still reluctant to lend to one another.

And even advocates of the bailout plan concede that the alternate measures may yet be needed if passage of the bill does not unfreeze credit markets.

"It doesn't fix everything," said Hogan. "It doesn't force the institutions to lend to each other or lend to consumers and businesses. That's why they'll hold onto these alternatives. I think you need to keep dry powder if you have to use them in the future.