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Mortgage securities have grown into a $14 trillion asset class.  We have painfully learned how dependent our stock market is upon these illiquid debt obligations. Many, including myself, have voiced the solution to temporarily eliminate mark-to-market accounting requirements in order to give these securities time to recover alongside their real estate collateral.  We all know that this is a cyclical downturn in housing that will eventually turn, and we also know that the hastiness of mark-to-market valuations should never have been allowed to destroy so many reputable financial institutions.  

However, I now have a better idea. We need a more permanent solution than a suspension of accounting regulations or a bailout.   If we don't solve this, it will happen again.  The solution is the same solution that is used in other investable asset classes; Ben Bernanke and Hank Paulson need to create a mortgage specialist fund to buy securities when no buyers exist.  The specialist acts as the market maker to facilitate normal trading conditions during abnormal circumstances.  Just as every stock should have a specialist who is ready to step in and buy or sell as many shares as needed to ensure a fair and orderly market, so too should mortgage securities.

With the leadership of Bernanke and Paulson, Congress could turn this $700 billion bailout plan into a permanent specialist fund whose job is to provide constant liquidity for these mortgages.  The private sector could throw in another $300 billion to create a $1 trillion specialist fund whose objective is to manage large movements by trading out of their own inventory.  If there is a large shift in demand on the buy or sell side, the mortgage security specialist will step in and sell out of their inventory to meet the demand until the gap has been narrowed.  

If this backstop had been in place, it would have prevented the overreaction that led to Merrill Lynch (MER) selling its mortgage portfolio of $30.6 billion to Lone Star for $6.7 billion or .22 on the dollar. Without this $24 billion loss it would have prevented Merrill investors from settling for a 60% markdown to a $29/share buyout from Bank of America (BAC).  Lehman (LEH) employees would still have a company to work for.  

The ironic thing is that everyone saw this housing downturn coming but nobody could do anything about it.  We were left with a $14 trillion asset class and no market.  Congress has mentioned that they only want to go through this bailout process once, so let's do it the right way.  We have a serious structural problem when mortgage default rates are less than 10%, yet the mortgage securities have lost 80% of their value.  Let's treat the cause instead of bandaging the symptoms.

Disclosure: None

Source: Bernanke & Paulson Need to Create a Mortgage Specialist Fund