Well, Paulson's plan was so weak that it seems like a free-fire zone up on Capitol Hill, from all reports about "what to do now".
A "BRADY" RESTRUCTURING FOR CDOs?
After a day's thought and listening to people wing-flap (always a good approach, even if we may poke fun), I've decided that divide and conquer is still the best strategy.
Divide the problem into two components, at least. The bad underlying mortgage securities and the bad derivatives on those securities.
- 1. The FED lends its balance sheet for the first part, for the bad underlying assets. These will eventually trade, at a price, once the depth of the downturn is known. Along the way, the institutions holding them will have the flexibility and imperative to "manage" the portfolio or, if they can, to sell it on, to a vulture specialist.
- 2. At least for the CDO part of the derivatives problem, I'd suggest something like a "Brady" restructuring of all CDO assets. This will allow these instruments to become tradable, quickly, at least as much as they can be (not too many people around to trade them, much, any longer). Mark-to-market can continue, as it should, with waivers granted for BIS capital requirements...
The third part would be the CDS, or credit-default swaps (at least as much as one can tell from a distance - there may be other moving parts).
At this time, I continue to believe that some type of forced netting is required to "unwind" these contracts. Not sure there is even an existing regulatory framework to make that doable or what the size of the problem is ...
THE BOTTOM-UP APPROACH
The other approach is a bottom-up approach, with a fundamentally different tact.
You "reflate" the whole financial mess by going in and backstopping the "bad" mortgages that are being foreclosed on. The Treasury/Congress pass legislation capping step-up rates and putting a floor under certain loans that qualify as having been "sub-prime" or near-prime.
You don't stop foreclosures (because some *must* occur), but you go in and guarantee a minimum interest rate on sub-prime mortgages. The government starts buying up 'defaulted' loans (as it did during the Great Depression, as best I recall).
A minimum interest-rate guarantee will give people a "risk-free" assumption to use in valuing the securities (and the derivatives which are keyed to them). Once there is a floor and people can model a series of "known" or "guaranteed" cash flows, the house of cards will "reflate" rather quickly, I'd wager.
This option will cost "real money"...
