The Paulson $700 billion Plan

Treas. Sec'y Paulson has opted to follow the advice of some
Democrats and independent economists and wants Congressional
approval to buy up to $700 billion of CMOs, mortagages and
related debt from domestically HQ'd financial institutions. The
hope is that by buying up these toxic loans in a reverse auction
(lowest offers accepted), confidence might return to seized up
financial and capital markets.

There is no stable or reliable market for this paper, and values,
when assigned, have an arbitrary air. I am confident looking at
actual loss experiences net of foreclosure proceeds in housing
plus realistic measures of home price declines that the actual
pool of mortgages viewed discreetly is worh considerably more
than the paper is being valued in securitized form.

From a pure economic perspective, the bailout program does
not make sense, so I do not know whether the alleviation of
so much suspect paper will end the seized up condition in the
markets. I hope so. I also hope that Congress and / or the
Treasury manadates the de-securitization of this paper and that
it buys the tranches it needs to complete this process. I would
also urge regulators to view the value of such securitized assets
remaining on the books of intermediaries in terms of their
economic value. If I was a bank CEO stuck with this paper, I
would be loathe to give it up for less than it was worth only
then have to raise capital dilutively. This deal stinks, and as
readers of the blog know, I have several times argued against
mark to market pricing for all esoteric assets.

So far the banking system has held up well, keeping capital
intact through raising additional funds to cover losses. This
auction process conceived by Mr. Paulson will be a major test
for the system and if panicky banks over - dump the toxic
paper at the Treasury, the system will be liquid although
significantly capital impaired.