The financial markets are choking to death on a glut of unmarketable securities, and the U.S. government is reaching the end of its string in selectively bailing out individual banks and institutions.
Continuing to save selected investors would set a bad precedent and would represent a slippery slope. If you bail out the Chinese bank that bought a bad group of mortgages, how can you say no to the barber in Sacramento who bought an extra condo at the wrong price?
It is doubtful that Congress will know what to do, and we know the Bush administration has no ability to handle the crisis. Selective use of the Fed's Discount Window could be the answer.
Under more normal circumstances, the Fed uses the Discount Window to pump money into the economy. To get access to funds, they loan the Fed the U.S. Treasury Bonds and other high-grade bonds they hold. It is called the Discount Window, because the Fed discounts, or marks down, the value of the collateral, to make sure the government and taxpayers don't take a bath.
The best way to pump money into the economy would be through a modified use of this facility. Instead of putting up U.S. Treasurys and high-grade bonds, the banks would put up the low-grade securities that are choking the system.
Stable banks might be able to borrow 80 cents on the dollar for the best securities, but some of the stuff they currently hold is worth much less. No one knows the true value. That is part of the reason they are not selling.
So, to protect the taxpayers, the government should buy the securities in something of a reverse auction. The Fed would announce that it plans to buy a certain amount of debt each day, say $10 billion.
The banks would price their securities and offer them to the Fed. The Fed would take the collateral that represented the best deal for the taxpayers. The next day, the Fed would announce another auction.
When it got to the point where the quality and price of the securities did not represent excellent value, then it would be time to reject the bids and close the Discount Window.
This would not mean that there would not be pain. If institutions did not hold enough good paper, they would fail. But it is a way to address the liquidity crisis without bailing out bad investments. The government/people would always be getting good value in exchange for their cash. The people who underwrote bad mortgages would still suffer the loss.
This would not be a substitute for good regulation of the financial industry, but to paraphrase Donald Rumsfeld, You go into recession with the financial system you have, not the one you want to have.