I think we can address the "credit crisis" more cheaply and more effectively than under the bailout. Instead of buying problematic securities outright, we should insure them against default. It goes like this:
- The immediate problem is that banks won't write enough loans to sustain the current level of economic activity.
- And they won't do so because other banks won't buy those loans.
- And other banks won't buy those loans because they fear that the issuing banks won't be able to repay them.
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- And issuing banks might not be able to repay them because they have to use increasing amounts of cash for reserves to provide collateral for other loans they took out to buy securities (such as mortgage-backed bonds and CDOs) whose prices are falling due to, e.g., mortgage defaults.
- And banks are selling those securities to raise cash to fund their reserves, which depresses the securities' market prices.
- And that means that other banks holding those securities need to raise even more cash for reserves to support the loans that they used to buy the securities.
- Thus, there is a vicious cycle of falling prices for mortgage-backed securities and increasing collateral requirements.
- If we interrupt this cycle, banks won't have to dedicate as much cash to reserves against existing borrowings, leaving more free to repay future borrowings, and thus increasing other banks' confidence that those future borrowings will be repaid.
- The "bailout" attempted to interrupt this cycle by directly buying the problematic securities, thus establishing a minimum price for them -- and therefore a maximum loss to the banks that lent the cash used to purchase them.
- We can also interrupt the cycle by insuring the loans used to buy the problematic securities. This also sets a floor on how much the banks that lent the cash used to purchase them will lose. That will increase their confidence that they'll be repaid, encouraging them to make more loans now.
- Insuring the securities-purchase loans probably will also be significantly cheaper than the "bailout", since the government will pay only if the borrowing banks default on those loans.
- The government could discourage banks from willfully defaulting by requiring a defaulting bank to issue shares in itself (or warrants to purchase shares in itself) to the government. This approach would also help the government recover some of the costs of the insurance payouts.