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I've just read Devilstower's wonderful explanation of what got us into the current economic mess.  I am a physicist not an economist, but I would like to throw out some ideas for a way forward to see if they make sense and if people with greater economic knowledge than I can comment.  More below the fold.

First, to define the problem (I'll assume anyone reading this has read Devilstower's post linked above).  It seems to me there are three basic problems:

  1. Lots of insecure mortgages.  Banks were given false confidence by default credit swaps (essentially an insurance policy on loans) and so gave out loans to very non credit worthy people, who are now beginning to default in droves as the value of their home drops far below the cost of their mortgage.
  1. Banking institutions that have grown too big to fail.  
  1. A gigantic (on the order of tens of trillions of dollars) unregulated market in Credit Default Swaps (CDS).  The price of these CDSs is so high because of speculative trading, not because of the intrinsic value of the CDS, which is a liability as much as an asset.

It seems to me any attempt at a fix needs to start with the mortgages.  If the homeowners don't default, there is no liability associated with a CDS (though the CDS is still valued at much higher than it is worth).  Second, the CDS market is unsustainable.  The CDSs have become so inflated in price due to speculation, and there is no way for the paper value of the CDS to ever be paid in cash (the CDS market is in the tens of trillions of dollars).  These CDSs should be allowed to die.  The government should not be allowed to buy CDSs unless they have been valued based on their expected yield from insurance payout, not based on the over-inflated price they were bought for.  In addition, the government needs to step in and regulate the CDS market just like it does the stock market to prevent speculation.  Next of course is the banks that are "too big to fail."  It seems to me all the government needs to do is put back in place the protections that were removed in the Gramm-Leach-Bliley Act.  This will require breaking apart the mega banks that have formed and the details of that will be difficult, but once the principle can be agreed upon all that's left to work out are details.  Last, what to do about companies that collapse because they now have way more debt on their books than assets (due to the CDS devaluation)?  In my opinion, they should be allowed to go bankrupt.  If they are vital to American security or economy, then the government should step in and oversee the sale of vital company assets to ensure they remain in America and able to function.  Alternately, the government could temporarily nationalize those parts of the company deemed strategically important, or a new type of bankruptcy can be created to allow these companies to shed their CDS debt while retaining their vital assets (this will have to be done carefully).  What do you think?  Does this make sense, or am I missing something?  The principles seem pretty straightforward to me, but like I said I'm not an economist.

On a related tangent, any solution MUST explicitly state what the problem is and how a proposed solution would address it.  Paulson's current plan, as I understand it, states that the problem is companies have lots of bad assets (the CDSs).  His solution is for the govt to buy them, thus restoring solvency to the companies.  It should be obvious at the outset that won't work; there isn't enough money in the system to buy even a significant fraction of the total number of CDS assets!  Any plan to Congress should have a detailed connect the dots approach tying problems to solutions.  Congressman (and the American public) are not too stupid to understand anything the economists understand, all they lack is the training.  Any bailout with such a large pricetag should be explained and agreed upon in detail so that Congress can see they are not wasting what remains of America's vital assets.

Please respond with any criticisms or suggestions (especially with details) of what I've laid out here.  I will try to update as my busy schedule permits.

Originally posted to ebor on Tue Sep 23, 2008 at 02:50 AM PDT.

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