Let's face it. No matter what plan is finally chosen, the taxpayer is going to have to foot the bill for fixing the current liquidity crisis facing Wall Street. The implications of not solving this are too dire to consider otherwise.
But the choice between a "market based" solution - as presented by the administration and a "strings attached" solution that is focused on making the bad actors pay for thier roles in the debacle while inflicing pain on the overall economy is a false one.
I argue that the only solution for the problem we face is a market driven one... just not the one presented by Paulson. One that won't stick us with the bill...
Any other solution would force the government into the role of choosing winners and losers in the process of fixing the mess - an odious concept to most Americans - especially if some of those "winners" are folks that caused the problem in the first place - be they Wall Street banks or your neighbor that way overpaid for their house. This is why "strings attached" ideas won't gain any traction.
What Congress seems to be missing is that they hold all of the cards in this negotiation. Congress could easily force Wall Street to punish their own through a market mechanism if they had any sense at all.
Let's start with why we care. Arguably everyone who was culpable in creating this mess, homeowners that overreached, mortgage companies that let them or worse, banks that syndicated crap, and investors that bought the crap knowing if it all fell apart tommorrow they already made so much in management fees that it wouldn't matter to them personally, they all should get what is coming to them. The problem is that were we to "let the chips fall as the may" the process would have dire consequences for the U.S. economy and for the vast majority of Americans that are innocent bystanders in this travesty. Hence the bailout.
The bailout, however, isn't about making people whole, its about making sure the capital markets keep working. To do that we will need to get the cancer (those bonds of questionable value) off of the books of Wall Street companies so that the capital markets can recover. Its the risk of the unknown, not that there are losses - but that its impossible to determine how big those losses are, that is hurting the liquidity of the market. The goal of the bailout is to remove the risk - not the loss. If the loss gets removed as part of the risk removal - well that's the price of fixing the problem. The conventional wisdom is that the gov't. will have to eat that loss to get rid of the risk - but its wrong.
Paulson wants to bail all of the firms out - I would if I were a Wall Street manager of firms that stood to be undone by bad business decisions. The reality is that some, if not most, of the paper out there has real value - the problem is that investors don't care - they are treating it all as worthless because of the risk it poses to them. This means financial companies with good mortgage CDS on their books (or at least they think are good, or may be good in the future) are being treated no different than those with bad CDS by the market - this is the root of the liquidity problem.
The only way to fix this is to get those CDS out of the market - but why should a company that has made good decisions - but is being penalized by the market for the bad decisions of their peers agree to bailout terms that penalize their shareholders (read management) to benefit the greater good. They won't, its not their job - but then again that's not our concern - our concern is to restore confidence in those firms balance sheets - its up to the firms to decide if they want to participate.
The flaw in the Paulson plan is that it assumes that in order to get those that don't need help to participate for the greater good of market stability that it must give something to those firms (and the bad ones too) to incent participation. This is so wrong.
What is ignored in that assumption is that the good firms don't gain from a return to normalcy. Right now those bonds are worthless - even if they think, or even know that they have value - because there is no market for them. Firms with what they think are good bonds would rather take that risk that they will have value down the road rather than take a known loss sale to the government - even if that insures prolonged liquidity problems - essentially shifting their risk onto the common good with the assumption that the government will assume that risk for them by making them whole. Why pay for the value of a return to normalcy if you can convince the government to fix the problem for free (and help your friends at other banks too boot).
But there is another path...
What the government needs to do is to pit Wall Street against itself and let the market sort out the winners and losers - without sticking it to the taxpayer. There is a simple way to do this. The government doesn't need to buy all of the bad CDS to fix the liquidity process, it only needs to buy enough to restore faith in the markets - and this is a subset of the overall market. The government needs to set the terms by which they will be willing to purchase CDS, the highest the market will bear - including equity stakes, etc. - but in doing so announce that they will only buy a subset of what is out there - and once the auction is over - no more gov't. money for those bonds. Firms can decide if they will play or not on the government's terms (which should be as cheaply as possible to meet the needs of restoring liquidity). But what about the bonds not bought?
At the same time the government will create a pool of capital (or an insurance pool of guarantees), at attractive rates, that is equal to the remainder of the outstanding CDS market debt. Access to this pool would then be provided only to firms that participated in the auction, and only to be used to purchase assets of firms that chose not to and now were failing due to that decision.
This would do several things.
1.) It would insure that the auction would succeed. Firms wouldn't have to partake - but they would have to weigh the impact of not getting rid of their CDS obligations on their business going forward knowing that if they did fail others would be at the ready and funded to step in an buy them at a discounted price. It would put a value on the government's actions to restore liquidity which would be reflected in the quailty of the CDS offered at auction.
2.) It would provide investors with a level of guarantee. CDS would no longer be a bottomless risk. Investors would either know the firm is CDS free or that they have enough faith in the CDS investments in the face of some pretty dire implications if they are wrong. Either way the market will have confidence, and therefore liquidity again - at prices reflecting the choices of the firms in the market rather than some arbitrary amount set by the government.
3.) It will cost us a ton less than Paulson's blank check. There is huge incentives for both good and bad CDS to be sold to the government - which means it can drive its own terms with regard to equity to offset that expense not to mention acquire quality assets.
4.) The good firms will win the auction and then buy the bad firm in bankruptcy but without market turmoil - because with stronger balance sheets they can afford to offer the government more than the bad firms - thereby capturing the scarce dollars allocated for CDS repurchase. Bank failures won't be a shock to the markets because the markets know that the failure is underwritten by the government. Auction winners will basically win the right to purchase those who can't afford to compete, due to their actions in creating this mess, with help from the gov't. This wouldn't cost the government much, if anything, penalize the bad actors for their past actions and incent future self-policing by not setting an example of bailing out the bad individuals (firms in this case) for the common good.