I think, as Bill Gross suggested, the solution is for the Federal government to start writing "checks" to homeowners. Wait, don't throw eggs at me yet. (You all have plenty of time at the end of this speech to do so).
This is what I think is logically how we can implement the strategy while targeting the root of the problem - and only the root.
First create at Federal Board of Housing Support (FBHoS). They will implement a pilot project, which will put a price guarantee for California home owners, at no cost to the home owners.
It's like this, use some inflation-adjusted price over the "most accurate" proxy of that particular home in 1997 as a price to set the put option strike, given freely to the Californian homeowners. The option only covers one transaction from the date of issue.
The board will use all available means to determine the most likely starting price for the house in 1997, before applying some measure of inflation explicitly on the starting price.
For example, a house selling in Riverside, CA, for 250k in 1997, will be delivered a put option for about 400k, with some restrictions on selling costs etc. to prevent outright fraud. Then "force" all pertinent variables tied to that house to follow that price, including real estate taxes, and more importantly, the maximum assesment price allowed for the property when used to obtain mortgage loan(s).
Suppose the most comparable, or even that house itself was last traded, in Dec 2006, for 690k. The borrower will not be affected in anyway, so long as she is not selling the house. She only will sell if a) couldn't afford the monthly payments (indicating poor financial planning when she bought), and b) panic investor who wants easy money.
People who own their houses before 1997, would not be the least affected by this decision. Needless to say, if there is any 100% cashout among these, then by definition this is no different from the transaction I described in the previous paragraph.
The effect will in my opinion be immediate, surely less than a year. The most reliable housing price is the rent equivalent, in the long run. Therefore a supply and demand stabilization will occur as the marginal transaction is set at the approximately correct intersection of supply and demand curve - by force. The option costs in my opinion may be much, much smaller than the alternatives, which is the slow bleed of the housing and banking system over a period of 10 years.
Why did I say that? In a "slow-bleed" environment, where the yields are adjusting, but never quite enough in every marginal transaction, will lead to almost certain losses for every $1 of investments made during this period, especially if inevitably leverage is involved in the transactions.
Writing checks at the mortgage level (SIV bailouts, for example), do not address the root of the problem. It is akin to trying to "fix" a derivative price so that they are more and more divergent from its corresponding underlying. Even if in the short term such effort stems the eventual collapse, the economic distortion can be immense! Just think of backsolving implied volatility of 1 million percent, for those who are still following my argument up to this point.
The house is still fallling in price, and the loans underlying it are sucking every marginal investors money everytime someone is foolish enough to lend to the homeowner. In the end, wouldn't the going house price be the price adjusted anyway? The five years of damage however, would be worth multiples of that house price, not to mention the rapidly spreading impact to the broader economy.
This one time adjustment will break the circular downward trip of credit-house prices dynamics. It will cost little assuming supply and demand will on average prevails so that the put option can be idealized as worthless.
It will more importantly, drive out two classes of economic participant out to face reality and stop retarding the economy by their resource misallocation:
The borrower who didn't plan carefully and cannot afford the loan. The lenders who abandoned logical lending practices and gave money away to economically absurd projects, such as zero down, option arms, etc.
After that, FBHoS can focus mostly on mortgage industry regulations and housing price monitoring. Also, I should mention that the pilot project should be aimed exclusively at California to start, as to gain understanding of the unraveling dynamics. Then the same projects can be applied as needed in other areas of the country.
I should note the proposed program probably would have the reverse impact in areas undergoing real economic adjustments, such as parts of Michigan and Ohio.
Finally, the trading strategy from my discussion need not focus exclusively on the acceptance of the suggestion, but rather its refusal. Go take as big a short as you can afford through leveraged investments (puts, ultrashorts) on projects related to California housing and "creative" mortgage banking. Mathematically, to the limit that my argument is accepted, the convergence of price to the target price (IMHO, zero) is faster. The only thing it changes is the multiple number of times housing-related mispricing that occur within the next few years will go down to one final adjustment.
So let's write a check, and make the return journey from banana republic faster and less painful.
Disclosure: Author has a long position in some of the above-mentioned securities