WONKESS

Highway Bank Robbery...

I am not even going to attempt to go into detail about the enlarged and much sweetened government bailout package with A.I.G. that is being reported today.  Yves at Naked Capitalism has a beautiful point-by-point dissection of what is going on, and I encourage everyone to read it.

For those who get lost in the technical jargon, I'll just do a short summary here.

• The initial AIG rescue package was: a $85 billion 2-year loan, interest rate at Libor + 8.5%, and loan is secured by assets of AIG.  In return government gets 79.9% stake in AIG.
• Early in October, the government lent AIG an additional $37.8 billion, gets nothing in return.
• This weekend, the government has promised AIG another $27.2 billion (for a total of $150 billion).  In addition, the terms of the $150 billion are being entirely rewritten (as compared to the initial AIG package) and will now look like this (bold to show what has changed from original terms):
  • $60 billion will be a 5-year loan, interest rate at Libor + 3%
  • $40 billion will come out of TARP, and government will get preferred shares, with 10% annual dividends.
  • $30 billion will go into a separate entity that will buy up the collateralized debt obligations which AIG had been giving guarantees (via credit default swaps) on.  (AIG will contribute $5 billion into the entity.)  See below discussion.
  • Though I can't find this last bit, I'm assuming the last $20 billion will go into a second entity that will do similar securities purchases.
  • The government will continue to own a 79.9% equity stake in AIG.

I have such a violent reaction to the government investment in the special entities that I feel this urge to throttle the current administration with my bare hands.  This is what is going on.  First, the reason that AIG is in such bad shape is because they were guaranteeing some of these very bad asset backed securities that we've all been hearing about, in this case, collateralized debt obligations (CDOs).  What this means is that if you bought one of these guarantees from AIG, IF the CDO defaults, you have the right to collect the face value of the CDO from AIG (I've written about this previously at MOMocrats).  This has been problematic for AIG because the premium they were collecting to insure these CDOs was magnitudes less than the obligations they've now taken on (remember, this is all because these banker brainiacs believed that never in a million years could such CDOs default, so the premiums were, in their minds, free money).

Now that many of these CDOs are on the verge of collapse, things are extremely problematic for AIG.

What the government proposes to do, with these special entities, is to buy some of the most vulnerable and worst performing CDOs underlying AIG's guarantees.  And they propose to buy them at 50 cents to the dollar across all tranches.  What does this do?  Well, by purchasing the CDOs, the government is effectively preventing the possibility of their default, and therefor, preventing AIG from ever having to make good on its guarantees.

Why is this a problem???  As Yves notes, "Recall that in Merrill's not-all-that-long-ago sale of its super-senior CDOs (the very best tranches) it got a nominal price of 22 cents on the dollar... [and the] hedge fund Lone Star paid only 25% of that amount (or 5.5 cents) in cash, the rest was contingent on performance. So Merrill might have sold the CDOs for as little as [5.5 cents on the dollar]."

In the best case scenario, the government is paying twice the amount that Merrill was able to get on its super-senior tranches of CDOs, in the worst case, the government is paying 10 times that amount.

For a super long time, the pro-business, rah-rah TARP people have been pointing out that the government bailouts are not handouts per se, as they were all structured as loans or government purchase of common or preferred shares.  There's been a lot of talk of government getting the "upside" or economic recovery. 

I'm sorry, but at this point, I'm struggling to see how the government can expect to "recover" anything on their "investments".  In an incredibly short amount of time (2 months), the AIG loan has gone from a libor +8.5% over two years to libor + 3% over five year, reflecting the all too precarious situation AIG is in (they can't even afford to make interest payments on the very cheap money they're getting).  In addition, if the Merrill CDO numbers are correct, you're going to have to see a 10 fold correction of the CDO prices before the government will net even on the purchase of CDOs, let's not even talk about the disappearing possibility of getting to any upside.

On a complete aside, I think this is an interesting approach for dealing with the CDS problem for PRIVATE financial enterprises.  One of the biggest problems with the CDS market is that there were people who did not hold the underlying security and were still buying the guarantees.  (Which is why the CDS market is estimated to have a nominal value upwards of $60+ trillion (under dispute).)   This means that even though you never bought a CDO (for example) you could still collect the full face value of the CDO from the guarantor if that CDO defaults.  And since you paid only pennies on the dollar for the guarantee, you could make out like a flamin' bandit.

So if I was an issuer of CDSs, I would totally take any last pots of money I had and buy out the CDOs (or whatever ABS, RMBS, etc... that I had enhanced) from their holders.  Most of these instruments are dirt cheap right now, and beats paying out the full value times however many CDS contracts I have outstanding.

J and I had a big fight about this last night, with him saying that he finds this strategy completely unfair, since it would be interference with fulfilling a contract.  I called bullshit on him, pointing out that interference is problematic in contracts only when you prevent the counterparty from fulfilling their obligations under the contract, not when you do whatever is possible on your side to prevent triggering a payout event (like under an insurance contract).  J kept doing the "I can't believe you're so stupid," hands over his despairing eyes thing that he does.

Yeah, we have fights about these things.  Whatever, this blog isn't called Wonkess for no reason.

Update: William Buiter has a post up at the FT asking that question to end all questions - is it time to let AIG fail?  My favorite parts:

No doubt a lot of CDS contracts written on AIG debt would be activated by a default, but the aftermath of Lehman’s filing for bankruptcy protection demonstrated that the process of unwinding and settleing the CDS claims was remarkably orderly and much less destructive than feared.

and

Here we run again into the incomprehensible fact that, almost 15 months after the start of the crisis, the US Federal authorities have not yet created a special resolution regime (SRR) with prompt corrective action (PCA) powers  that would allow a duly appointed Administrator or Conservator to take any systemically important institution into Administration/Conservatorship before the normal tests for insolvency (balance sheet insolvency or liquidity insolvency) have been met.  The Conservator would replace board and management and suspend the voting rights and other decision rights of the shareholders.  No dividends, share repurchases or other transfers of resources to the old shareholders could take place while the Conservatorship is in effect.  The Conservator should be able to impose charges (haircuts) on all unsecured debt holders and other unsecured creditors, regardless of seniority.  The Conservator would also be able to impose mandatory debt-to-equity conversions on all unsecured creditors and debt holders, with or without first extinguishing the equity of the old shareholders.  The Conservator would have full authority to sell assets and to restructure the balance sheet and the activities of the business in any way deemed appropriate and lawful.  Finally, the Consevator would have the power to liquidate the company.

Update (2): More white hot anger from Interfluidity and Clusterstock.

I Saw the Dow Today, Oh Boy...

Aw, man, I love Yves:

[E]ven though we have very strong opinions, we do not give investment advice. What we provide (aside from commentary) might be regarded as investment hazard warnings. You may nevertheless decide to go ahead after reading what we offer, but we hope you will proceed with caution. One thing most investors fail to realize (and we have made this mistake ourselves) is the warning from mathematician and market maven Benoit Mandelbrot: ""Markets are very, very risky – more risky than the standard theories assume."

The thought for today is that oversold does not necessarily mean undervalued. And a second thought is that the stock market increasingly seems to serve as a quick proxy for how the economy is doing, when it has a strong propensity to give false positives.

Even perennial bear Marc Faber, who has only 7-8% of his portfolio in stocks (and by the sound of it, not US ones either), thinks the market was primed for a technical rally but is not keen on the long-term prospects for the US economy:

"The governments in this world have no other option but to print money. That will lead down the road to inflation,'' Faber said. "You don't need to be an economist graduated from Harvard to know we're already in a recession. They will just put white paint on a crumbling building...."

"To rebuild economic health in the United States, you need a serious recession that will last several years,'' he said. "The patient that got drunk on credit growth needs to go into rehabilitation. To give him more alcohol, the way the Fed and the Treasury propose to do, is the wrong medicine.''
So whether or not the market signal is correct, we don't see the credit/economic crisis as close to resolution. The fact that we averted a systemic meltdown is not the same as saying the powers that be found a cure.

The dollar has remained unexpectedly strong (that view is based on disgruntled sounds I have heard from various sources). Most expected continued dollar weakness, although a minority saw the euro taking a big hit before a dollar slide resumed. An orderly fall in the dollar would hopefully not discomfit our trade partners unduly, but a disorderly slide would.

The big unresolved issue now is that even though we appear to have avoided a financial meltdown (even Nouriel Roubini thinks that risk has passed), we are still going to see considerable deleveraging, due primarily to the fact that lenders are in no mood to take risk, but compounded by the fact that consumers and businesses are feeling plenty shell-shocked.

We have noted before that even if the Fed gets Libor and the interbank risk measures associated with it down to less stressed levels, that does not mean we are back to status quo ante. First, rates could improve at diminished levels of activity. Second, even if banks do lend to each other, that does not mean that they are going to resume extending credit on anything other than very cautious terms to customers.

Remarkably, Anna Schwartz, who with Milton Friedman, was the author of the pathbreaking monetary study of the Depression that concluded the worst would have been averted had central banks injected more liquidity, said in an interview with the Wall Street Journal that the Fed was using the wrong remedy to this crisis, and was treating it as a liquidity crisis when it is in fact a solvency crisis.

So not surprisingly, with an economy on the downturn, even if banks do decide to become freer with lending to their peers, evidence is mounting that they are not going to be as accommodating with their customers. From Andrew Ross Sorkin at the New York Times:

But Mr. Paulson is making a big assumption about confidence, because until the real economy recovers — which could take more than a year — lending to Main Street is unlikely to return rapidly to normal levels.

"It doesn’t matter how much Hank Paulson gives us," said an influential senior official at a big bank that received money from the government, "no one is going to lend a nickel until the economy turns."

From Robert Reich:

The Dow is see-sawing but the reality is that the Bailout of All Bailouts isn't working. Credit markets are largely still frozen. Despite all the money going directly to the big banks, despite all the government guarantees and loans and special tax breaks, despite the shot-gun weddings and bank mergers, despite the willingness of the Treasury and the Fed to do almost whatever the banks have asked, the reality is that credit is not flowing. It's not flowing to distressed homeowners. It's not flowing to small businesses. It's not flowing to would-be homeowners with good credit ratings. Students are having a harder time borrowing for their tuition. Auto loans are drying up.

Why? Because the underlying problem isn't a liquidity problem. As I've noted elsewhere, the problem is that lenders and investors don't trust they'll get their money back because no one trusts that the numbers that purport to value securities are anything but wishful thinking. The trouble, in a nutshell, is that the financial entrepreneurship of recent years -- the derivatives, credit default swaps, collateralized debt instruments, and so on -- has undermined all notion of true value.

Roubini now foresees a deep recession of at least two years' duration. That does not appear to be part of the newfound stock market cheer. Given Roubini's success in calling this credit crisis, I'd be loath to take a long-term bet against him.

I've been thinking about the gyrating market over the past few weeks, and really, the more it gyrates, the more upset I get.  Not so much because of my personal losses (I am one of those who tosses my quarterly statements under the bed) but because I hate how much importance we've begun to attribute to it.  It has become the holy grail: the path to great financial wealth, the source of easy money, and an oracle to policy-makers.  It's like really bad one-stop shopping.

For example, the whole bailout thing.  It's become a monstrous cacophony of "huzzah for government intervention" because the Dow climbs 500 points to "no, if you don't pass this we'll all DIE!!!" as the Dow drops 700 points when in reality, the stock market reflects nothing more than a bunch of trader's day to day belief of whether they can make short term gains on this day.

You know, I wouldn't even care so much if the insanity of the market was just self contained.  I just hate how much it's leaked into every other aspect of life.

Link of the Day: The Broker with Hands on their Faces Blog.  There are moments when you discover something and you wonder how you ever existed without it.

BailoutNation: Democrats Try to Rein in Paulson

From Bloomberg today:

Dodd, a Connecticut Democrat, is circulating a draft of his bill as Congress seeks to deal with a financial crisis that has been called the U.S.'s worst since the Great Depression.

The legislation requires Treasury to take an equity stake equal to the purchase price of the assets being bought. If the company isn't publicly traded, the government would take senior debt instead, placing it in the front of the line of debt holders for repayment in the event of a bankruptcy.

Dodd's proposal also would create a five-member oversight board to supervise the Treasury secretary's purchase and sale of distressed mortgage debt.

It would consist of the chairmen of the Federal Reserve, Federal Deposit Insurance Corp. and the Securities and Exchange Commission as well as two members from the financial industry designated by congressional leaders.

The board would be authorized to set up a so-called credit review company consisting of Treasury employees to study the soundness of the purchases. Under the plan, the government would be required to obtain an equity stake equal to the value of the debt that is purchased from the companies, including those whose shares are not publicly traded. The Treasury secretary would also be required to issue weekly public reports on the amount of assets bought and sold by the U.S.

Dodd is [also] proposing to penalize executives who take "inappropriate or excessive'' risks. The executive compensation and severance packages could be reduced if that is "in the public interest,'' the proposal says. It would also force executives to give back profits they earned that were based on company accounting measures that are later found to be inaccurate.

A couple of things:

(1) Why, oh why, would the oversight board consist of the Fed chair (Bernanke - tool), the FDIC chair (Bair - don't know anything about her, but the FDIC has not exactly managed risk well over these last few years), SEC head (Cox - tool) and two member of the FINANCIAL INDUSTRY??  Why don't we actually put some people on the board who - oh, I don't know - would be accountable to taxpayers??

(2) On principal, I like the idea that taxpayers may get upside of recovery (via equity).  In practice, I'm not sure there will be any upside.  Furthermore, given that this is already the game that we're playing with Freddie, Fannie and AIG, shouldn't the government be balancing out its own risk profile?  The bloomberg update says that the government would be senior debt in case of bankruptcy.  Does this mean senior debt even if there is no bankruptcy?  So that the banks that sell assets to the government would actually be on the hook for the difference between the price paid by the government and price ultimately recovered by the government?  That seems inordinately fair to me and would achieve the stabilizing/recapitalizing effect that Paulson was theoretically aiming for.  And I say theoretically, because the alternative is that he was aiming to fill his friend's pockets with one last cash infusion before the whole nutty tower comes crashing down.

(3) The executive penalties are too squishy.  I'd like to see more pushing for recovering bonuses from top executives (not just CEO, but I would say top 10-20 earners) for the past 2-3 years.  It's done in bankruptcy, so why not here?

Finally, the way that Paulson has managed this entire bailout package has been irresponsible and reprehensible.  He announced the bailout late last week, in fairly definitive terms, knowing that he had no authority to do so and that any package would have to get the approval of Congress.  So the market, incorporating his announcement, surged 3-4% each Thursday and Friday.  This meant that when the Democratic Congress, doing their constitutional duty to stop the friggin raping and bleeding of America, steps in and tries to patch up the plan as best they can, it inevitably sets the markets a-rattling again (note today's 300 point drop). 

So Paulson gets to be seen as savior and Congress as the bad guys.

Well, at least in the blogosphere, I'm seeing pretty unanimous anger by the taxpayers against this plan.  Let's hope that their righteous anger remains focused.

Real Alternatives to a $700 Billion Bailout

Over at Momocrats, I am urging all Americans to call or write their Representative or Senators and tell them that the $700 billion bailout plan being proposed by Paulson is unacceptable.  It's lack of transparency or accountability is astounding, even by the standards set by recent Fed/Treasury actions.  Here, I present some (far better) alternatives that have been presented by some of the best economic minds in our country.  I suggest that the current administration gets over its hubris in believing there is a single solution to this problem and that we should lay our trust, unquestioned, in a man who, as the one-time head of Goldman Sachs, has a very personal stake in the outcome of this bailout.

From Nouriel Roubini (subscription only link), who talks about another way we could have handled the AIG bailout (which is also a strategy applicable to the current bailout being discussed).

It is likely that AIG’s shareholders (both preferred and common) may be substantially wiped out; but then why does the government take only a 80% equity share in AIG? Why not 100% as it should? [Although Roubini does not mention it here, he knows, as most economist do, that the reason that the government took just under 80% of AIG is because this allows it to keep its ownership stake in AIG off the Treasury books, which keeps the entire transaction, and by implication, how bad it is for the American public, from being transparent.  -ed]  So, if by miracle, AIG is not liquidated, such private shareholders instead of being fully wiped out get any upside benefit from this government action.

...In the case of AIG it appears that the US “loan” has as collateral all of the assets of AIG; if this were to be the case (a point to be clarified as the Fed statement was not clear about the seniority of a loan that has equity-like characteristics) the creditors of AIG would not be scot free as the government claim would have priority over any other secured and unsecured creditors of AIG, including possibly the insurance policy holders of AIG.

If this is truly the case (and I say “if” because the Fed has not been fully clear on the nature of its claims in the pecking order of the capital structure of AIG) the objective of the Fed in its intervention on AIG (i.e. avoiding the systemic effects of a collapse of a large and too big to fail institution) may not be achieved: i.e. if the claims of the government are senior to those of all creditors of AIG then AIG bondholders and also other creditors of AIG get whacked if AIG is insolvent (i.e. if in the effective liquidation of AIG the assets of the firm are lower than its liabilities).

But if the action of the Fed are aimed at facilitating an orderly selling of AIG’s assets how does the Fed ensure that its investment in AIG is safe? In a formal bankruptcy (Chapter 7 and 11) there is a stay on the claims of a firm’ creditors; thus a roll-off of their claims cannot occur. But in this government takeover of AIG how does one ensure that such roll-off of claims does not occur?

The only way to avoid such risk is to impose a stay - like in a formal Chapter 7 or 11 – on such claims. But if the objective of the government was to avoid a disorderly workout that a formal bankruptcy would have entailed how does one ensure – short of an effective stay on all creditors claims – that the public money provided to AIG (the $85 billion “loan”) is not used by the unsecured creditors of AIG to roll off their exposure and run out of AIG scot free? Short of such a stay the apparent seniority of the government claims implies that any short term creditor of AIG should cut off its exposure and run. And if instead (“if” because again the Fed has not given any details on this crucial issue) the government claims are ensured by an effective stay on such creditors’ roll off then why did the government intervene in AIG rather than letting it go into Chapter 7 or Chapter 11 bankruptcy court?

So this is the conundrum of the government intervention in AIG: it was made to avoid a disorderly collapse of AIG with the provision of short term liquidity; but in order to avoid short term creditors of AIG to run and be full on their claims you need to impose an effective stay on such claims; otherwise some creditors are bailed out (those with short term claims who can run) and some creditors are whacked even more (those with longer term claims that are junior to the government) and such short term creditors become effectively senior to the government. But if the government has to be truly senior relative to all of the creditors of AIG you need to impose a stay on all creditors. And if you impose such a stay you whack all creditors, you impose losses on all the AIG debt holders and you risk the systemic panic and disaster that you wanted to avoid in the first place.

If this is the case it would have been better to push formally AIG in Chapter 11 or 7 bankruptcy court and then provide the government financial support in the form of traditional debtor-in-possession (DIP) financing. If this had been done such DIP financing would be formally – as provision of new money – senior to all of the other claims on the firm. So the government decision to avoid formal Chapter 11 (or 7) is puzzling: either the government loan is truly senior to all of the claims of AIG – in which case you need a formal stay to avoid short term creditors to run away (but such stay will impose the same potential systemic risks of a formal bankruptcy) – or if such a stay is not imposed then the government claims are junior to those of the short term creditors of AIG and the objective of avoiding a run on the claims of AIG cannot be avoided.

...[I]n the case of AIG we have a problem of solvency and the need for an orderly wind down of AIG so as to prevent a global systemic crisis. So it is rational for short term claimants of AIG to run if their claims are junior to those of the government. And if instead those claims were not junior (i.e. a stay is formally imposed) the systemic effects of such a stay will cause massive losses to all of the creditors of AIG and will thus not prevent the systemic crisis that the government intervention was meant to avoid.

The reality is that it would have been more honest and clean and proper to take AIG to bankruptcy court and then provide the government support (the $85 billion loan) in the form of a formal debtor-in-possession (DIP) financing. Why was this solution not taken? It is not clear. Going to court may imply a credit event that triggers formal default and consequences for creditors and CDS holders and the guarantees made by AG on toxic fixed income securities. But what has happened is effectively a credit event and such triggers should be occurring regardless of whether AIG goes into formal bankruptcy court or not. The Fed and Treasury should immediately clarify on whether their intervention includes or not a formal stay on all the creditors of AIG including the holders of the short term claims against AIG.

Any fuzziness and lack of transparency on this matter would be severely destabilizing for markets and investors. To truly safeguard the government claims such a stay should be imposed; and it is not imposed the government action will allow short term creditors of AIG to run scot free with two consequences: the government claims will be at risk putting taxpayers’ money at risk; and the claims of longer term creditors of AIG will be whacked more down the line as short term creditors were allowed to be bailed out. But in that case why should different creditors of AIG be treated differently with some being bailed out and some not and with the consequence that the bailout of some implies much bigger losses to the longer term creditors of AIG? Again a formal bankruptcy court would have allowed a more fair process for allocating losses between shareholders and short term and long term creditors of the firm.

The Fed statement is also fuzzy on the claims of the insurance policy holders of AIG. Are these insurance contracts junior or senior to the government claims? You may think that holders of standard insurance (life, casualty, etc.) should be treated as senior (in the same way as small depositors of banks are insured from loss)? But should only such policy holders (individuals and non-financial firms) should be bailed out and be senior or should also the holders of AIG insurance of fixed income assets (hundreds of billions of dollars of such insurance) be bailed out? If all of such insurance contracts are safe and made whole by the government why should the government bail out investors that bought insurance of toxic products (MBS, CDOs, etc) from AIG? There is no rationale for that.

...[I]nstead of doing the right thing – pushing AIG into bankruptcy court and providing government DIP financing – the Fed and Treasury have formally nationalized AIG and they have created a legal mess where there will be endless confusion and lack of transparency of the government claims relative to junior and senior creditors of AIG, short term creditors and long term creditors, insurance policy holders of a traditional sort and of a non-traditional sort (life and casualty holders versus bond insurance holders).

...[S]oon enough the transformation the USA into the USSRA (United Socialist State Republic of America) will be complete: we have defeated the USSRR to create a communist economy in the most advanced free market economy in the world. And calling it socialism (even socialism for the rich, the well connected and Wall Street) is giving a bad name even to a failed experiment like socialism; this is more akin to the creation of a corporatist state (like the Italian fascism or the Germany Third Reich) where private sector interest are protected (gains privatized and losses socialized) where the government is taken over by corrupt and reckless private interests.

Roubini apparently gives the plan a thumbs up, though I cannot comprehend the inconsistency between his aforementioned disdain for the AIG bailout compared to the current much larger and much kinder bailout.  (Sigh, another fallen hero).

From Steve Waldman over at Interfluidity, who offers a simply, yet elegant alternative:

I think we'll only get one shot to set things right by throwing a ton of money at the problem, so we'd better think carefully before we throw it at symptoms rather than causes. Trying to figure this out in a week before Congress goes off to reelect itself strikes me as ambitious. Broadly, my view is that if we are going to legislate, Congress should empower regulators to declare systemically important firms insolvent, write off existing common and preferred, fire incumbent management and unilaterally convert debt to equity as far up the capital structure as they need to go until the firms are unambiguously well-capitalized, with little or no public money involved. Going forward, investors should understand that firms that are too big to fail are too big to be debt-financed, and government enforcement of debt claims against such firms will be limited. If economies of scale are real, equityholders should be glad to reap them. Otherwise markets function better anyway when populated by small actors who compete rather than by behemoths who dominate. The government should not subsidize the many negative externalities of scale. Members of the Pigou Club might suggest that bigness should be taxed and diversity subsidized.

As far as the money is concerned, throw it at infrastructure. Increase worker bargaining power by offering Federally funded retraining sabbaticals for any worker over thirty who decides they want to retool. I'd rather see a new WPA than a new RTC. If it is true that during a debt deflation, the government can spend freely without fear of inflation, let's spend in a way that balances the economy, not in a manner that tries to ratify the imbalances that brought us here in the first place.

There's no such thing as a choice-free bailout. The government's largesse will go to some and not to others, and we have to decide. Don't believe self-styled technocrats who claim that science or the market tells them who deserves the tax- (or inflation-) payers' dollar. In a bail-out, there are winners and losers, and we get to pick. I think we should focus on a simple goal: Restructuring the economy so that the vast majority of Americans can afford a middle-class lifestyle with very little leverage on household or government balance sheets. That may be a radical suggestion in 2008, but our grandparents would have considered it only common sense.

Waldman is basically suggesting a structure more akin to the original RTC (Resolve Trust Company, formed in the aftermath of the S&L crisis), where all the institutions that need to go bankrupt go bankrupt first, then the government steps in with intervention.  The highlight is mine, my favorite part of the plan, beauteous in its simplicity and ultimate reliance on free-market decision making.

From Robert Reich (UC Berkeley):

Paulson is right that it makes sense to allow the big banks to wipe their balance sheets clean of as many bad loans as they can identify, and put them into a special agency that then sells them for as much as possible. The agency would bundle or unbundle the risky loans, slice and dice them as needed, with the goal of getting the most for them on world markets by creating a market for them.

But there's no reason taxpayers need to be involved in this. 

Whether you call it a reorganization under bankruptcy or just a hellova fire sale, the process should resemble chapter 11 under bankruptcy. Any big financial institution that wants to clear its books can opt in. But the price for opting in is this: Investors in these institutions lose the value of their equity. Executives lose the value of their options, and their pay (and the pay of their directors) is sharply limited. All the money from the fire sale goes to making creditors as whole as possible.

Meanwhile, policymakers work on a new set of regulations to ensure transparency on Wall Street -- governing disclosures, minimum capital requirements, avoidance of conflicts of interest, and better ensurance against stock manipulation -- so that, once the bad debts are off the books, the new numbers can be trusted.

I repeat: This isn't a crisis of solvency or liquidity; it's a crisis of trust.

From Luigi Zingales (U Chicago):

As during the Great Depression and in many debt restructurings, it makes sense in the current contingency to mandate a partial debt forgiveness or a debt-for-equity swap in the financial sector. It has the benefit of being a well-tested strategy in the private sector and it leaves the taxpayers out of the picture.  But if it is so simple, why no expert has mentioned it?

The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers’ expense than to bear their share of pain.  Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few.

Although these suggestions (and the many others that may be out there) all vary in specifics, they are all very similar in the following ways: all demand greater transparency, all demand that the current equity holders be wiped out first and all have at least taken into account the risk to the taxpayer.  Considerations that Paulson is apparently incapable of.

In parting, I leave you with this rather scary reader comment from Naked Capitalism:

I worked at [Wall Street firm you've heard of], but now I handle financial services for [a Congressman], and I was on the conference call that Paulson, Bernanke and the House Democratic Leadership held for all the members yesterday afternoon. It's supposed to be members only, but there's no way to enforce that if it's a conference call, and you may have already heard from other staff who were listening in.

Anyway, I wanted to let you know that, behind closed doors, Paulson describes the plan differently. He explicitly says that it will buy assets at above market prices (although he still claims that they are undervalued) because the holders won't sell at market prices. Anna Eshoo pressed him on how the government can compel the holders to sell, and he basically dodged the question. I think that's because he didn't want to admit that the government would just keep offering more and more.