Outtanames999

Where's the Bottom? Still Anybody's Guess

Nice concepts, but they're all predicated on the assumption that $700 billion is a real number that will actually be spent. I say it won't take anywhere near that amount to restore liquidity.

As long as the Fed starts buying a carefully calibrated set of tranches (e.g. 30/60/90 days past due payments, home in foreclosure for 3/6/12 months, etc. or something similar - you figure it out), designed to price recognizable types of paper assets, reference prices will be set. A few billion worth of such tranches should be all it takes for sideline cash to start moving in once it knows the price.

Regardless of whether the Fed buys high or low it won't matter. Whether it sets a floor or a ceiling, the market can adapt and establish a market price above or below the Fed's price. As soon as there is a Fed price, an avalanche of cascading mark to market adjustments across asset holders worldwide will immediately take place. In an instantaneous Bang! portfolios will be adjusted, assets can be bought and sold, and liquidity restored.

No one wants to be too early, thus they sit and wait. Only fools rush in, and therein lies the appropriate role for the Fed - to play the wise fool whose actions unlock liquidity by establishing prices. With the entire $700 billion at its disposal, even without spending another dime beyond some initial billion dollar tranches, the Fed will represent a threat to buy at its price that other parties will not be able to ignore.

In addtion, the banks who hold the bad paper now should be incentivized to continue holding a portion of it. In fact, the more they hold, the more the Fed should agree to buy. Similarly, the more capital they raise, the more bad paper the Fed should agree to buy. In other words, they need to earn the right to sell the bad paper to the Fed. They would have held some bad debt anyway, why shouldn't they continue to do so? They would continue to seek additional capital, why shouldn't they continue to do so and why shouldn't the Fed's solution be dependent on such actions? That would serve as a damper on the effects of the Fed's actions and serve to reduce the overall Fed contribution.

Paulson/Bernanke: $700 Billion at 'Hold to Maturity' Pricing

There's one more missing piece. A couple maybe. There is talk about dividing the banks into good banks (holding the good assets) and bad banks (holding the bad paper) and then the Fed buying out the bad paper.

But any buying of bad paper should include an incentive for the banks to hold some too. The more bad paper you keep on your books, the more bad paper the Fed will buy from you. There is no reason why the banks cannot hold onto to some of the bad paper. They would have some under any other market conditions, so they should have some now. Under no circumstances should any bank be allowed to sell 100% of its bad paper to the Fed.

There also should be conditions that encourage the banks to find additional capital, especially private equity, to strengthen their balance sheets. The more capital you bring in, the more bad paper the Fed will take off your hands.

As far as other conditions like equity and caps on pay, these and any other onerous conditions that anyone can come up with are absolutely necessary It is the only way to get their attention and make sure they will not ever screw up again.

The medicine has to taste so bad that they understand the cure is worse than the disease and suddenly that bad paper doesn't look so bad after all and it hurts just thinking about over leveraging.