Bailout: Here's How to Fix the Fix

I have posted diligently to Seeking Alpha for the past 19 months, sharing my thoughts on the overall market, sectors, and, most frequently, individual securities.  One subject that I have avoided has been politics.  After watching what had to be the most significant political blunder in my life Monday, I feel the need to be yet another voice on the issues at hand.

I began my career on a bond trading desk on Wall Street, so I understand clearly what it means to have to get one's position down.  I believe that Paulson and Bernanke have the right general idea regarding combating this massive illiquidity that has created the worst seize-up in the credit markets in modern history. 

I am libertarian in my beliefs, but even I recognize that there are certain times when the market fails, and a government solution can help restore order.  Where things were blown, I think, was through both the arrogant manner in which Paulson and Bernanke presented their plan--the threat of dire consequences if Congress didn't act quickly (in essence, hijacking the markets)--and their ultimate failure to come up with a plan that was sellable (you don't call it a "bailout"). 

I don't mean to put all of the blame on Paulson. Congress has come out the loser in "Are You Smarter Than a 5th Grader?". 

While I was initially disappointed with the House Republicans, both prior to and even after the vote, since it would seem they would rather aid no one for any reason and allow "the markets" to play out, I have come to understand their position perhaps a bit better.  

My point, though, isn't to cast blame and to criticize, but rather to propose a set of ideas that would both get to the core of the problem as well as be more palatable for all parties.  Perhaps parts of it aren't too different from some of the other ideas I have seen, but I do believe that I have a couple of unique angles.

Here is what I propose:

• Create a Government Agency to oversee the process.
• Fund the Agency with $100 billion by selling interest-guaranteed tax-exempt bonds.
• Create a list of eligible securities and assets for the program.
• Allow purchasers of eligible assets to purchase insurance (say for 3.33% of the principal).
• Insurance would cover the first 10% of losses.
• Suspend capital gains tax on any eligible securities held for more than a year.

This solution offers many advantages relative to the proposed Emergency Economic Stabilization Act of 2008:

• A significantly lower cost.
• More of a "market" solution, with the government regulating rather than implementing the process.
• Enough of a floor provided to entice risk capital into the market.

While I believe that most of the points of the plan are easy to understand, I want to walk through the mechanics of the program.  First, market participants would fund the up-front cost of $100 billion.  The government would guarantee tax-free income on the debt, but not the principal. 

I am assuming that a 10-year maturity and a tax-free yield of 10% would attract the risk capital necessary (but maybe it's 5 years and 20% and a partial principal guarantee).  While the bond-holders would be risking their principal, they would ultimately get it all back over 10 years, setting a "worst-case" that can be calculated as well as a "best-case" of full redemption at maturity. 

With this resource, insurance could be provided to cover losses on assets that have a current value of over $1.5 trillion.  The way this works is that the agency would receive fees of $50 billion to protect the first $150 billion in losses (10% of $1.5 trillion:  Insurance fees of $50 billion, essentially the first loss, and insurance fund of $100 billion).

While perhaps my numbers are off (more up-front needed, more insurance needed), the principle is that it is ludicrous to have to insure the full value of these assets.  The goal should be to help set a floor under risk-takers so that they can buy securities that by all accounts should actually prove to be great investments. 

They are killing the banks because there is no bid -- this plan would help establish a bid, with the market setting the price (not a government bureaucrat).  With some downside protection and the prospects of tax-free gain on the purchase of these distressed securities, I believe that the downward spiral would halt immediately.  It is quite possible that the mere existence of the program would lead to stability without the buyers taking full advantage of the insurance aspect (though they would receive the tax-break on any gains). 

This sounds so much better to me than a "$700 billion bailout".  Let's minimize the exposure of the taxpayers by incentivizing risk-takers to either fund the insurance program or to actually invest in the distressed securities. 

I believe that both sides of the aisle should find these attributes less challenging during this election season than the proposed plan. I am sure that I am neglecting a few key points, but I believe that the principles embedded in my proposed solution can serve as a framework.

Disclosure: None

Comments

[1worldcurrency:]

Stick to your libertarianism, which is a fifth grader's utopian philosophy. And keep your hands off my money. If the government wants to bail out someone with welfare it ought to someone old, sick, starving, or unemployed.

2008 Oct 02 03:18 AM

[Mr.G:]

There does need to be a real viable solution -that is a step in the right direction - Representative DeFazio also wrote another solution which was ignored and far less risky as well as less expensive - The Senate, the adminstration and the Fed seem to think that what actually started the problem is going to fix it - I have read enough opinions of experts on both sides of the fence to know it wont work -and it seems that those who warned of these problems a year and a half ago are still ignored . What I expect to see if this bailout passes is the 700 billion being used to prop up a very small amount of banks -so they can gobble up market share when the house of cards fall -I will assume it will be Bank of America- Goldman and Chase -what is about to be seen is the biggest consolidation of banking ever

2008 Oct 02 04:00 AM

[nobodyintexas:]

You sound more like a republican, why not let the republican party line of the free market solve this incredible pile of crap that has been created by the free market system. Wall Street , stock brokers, bankers and investment houses caused this, let them solve it. They could sell a few of their houses BMW.s, luxury boats and use some of their golden parachutes, stock options and off shore money to fund the initial money your plan calls for and they do like the special tax breaks

2008 Oct 02 05:53 AM

[Takayama:]

Who will benefit the most from this bailout? Maybe the group of people on the Goldman camp?
Stop this bailout. Keep the $700b in a strong fire-proof safe. And get Uncle Robin Hood to distribute this money to the homeless people of USA. So that the streets would have less crimes, and the drug pusher could change his career.

2008 Oct 03 03:50 AM