But the bailout plan is not equivalent because, as I mentioned in the original post, MBSs are no longer the issue. The cancer has spread. A cascade has already occurred. Institutions already had to sell other assets to cover their MBS losses using mark-to-market accounting for capital requirements.

This puts their total position in doubt, not just their MBS position. That’s what the forced investments in leading banks was all about–to convince people that at least these select institutions were solvent.

But I think the cost is far worse than the gain. The whole crisis was created by the quasi government status of Fannie and Freddie combined with political pressure. Now a good chunk of our entire banking system will be subject to the same pressure.

If the government was concerned about making capital available to Main Street, they should have expanded lending to Main Street directly through the SBA. Then once those loans were paid off, the government involvement would be over.

But now we’ve got a semi-permanent government finger in the pie of private institutions.

For those who don’t know what he’s talking about, here’s the example.

The connection between this puzzle and the markets is discussed in John Allen Paulos’ A Mathematician Plays the Stock Market

Relatedly, we should question the media’s role in fueling the crisis, see my post on dangerous ideas

From your write-up, you recognize the “seizing engine” nature of the crisis. If intra-institutional liquidity is the oil in the engine, then when that oil has gone a’missin, there isn’t much that regular market forces can do to get the crank turning again.

I’m not sure if it’s a good analogy, but for better or worse, here’s how I think of Paulson’s proposoal to allow the government to be a clearinghouse for the worst of the toxic waste on balance sheets:

Have you heard the blue-eye-green-eye-psychopaths on an
island riddle? In it and similar puzzles, an outsider comes in and makes a declaration. Usually it’s declaration of a fact that the other participants are already aware of (e.g. — “people on this island have blue eyes”), but by dint of the observation coming from an independent actor at a fixed moment in time, it carries extra information. Now everybody knows that everybody knows the declared fact.

Paulson is effectively serving that function. He’s saying, “nobody is willing to trade because they don’t know if their counterparty is on the verge of bankrupcy or highly solvent. Well, I’m here to tell you that their assets are worth X.” Now all participants can act because not only has the value of the mystery assets been declared, but said
value is being backed by a fairly reliable source and the downside is now somewhat knowable.

It’s hard to say whether free market mechanisms alone could converge on some kind of valuation for those assets in time to get the engine turning over again. If they take too long, the stasis will have secondary consequences that are long lasting.

But it shouldn’t bail out people who took risks that simply didn’t pan out. It’s not a crisp line, though. What to do about Money Market Funds? On the one hand, account holders should deserve to bear some loss because they had the benefit of higher interest rates. On the other hand, you don’t want everyone pulling out of their Money Market Funds at once. Perhaps a floor of .90 on the dollar before FDIC insurance kicks in?

Your absolutely right about short selling and naked short selling. We need the former to provide discipline but the latter is not actually a good faith bet.

I will point out that there are some big players with cash on the sidelines that are licking their chops and saying that there this is a once in a lifetime opportunity for investors in undervalued equities. So in some sense I agree that the problem may be self-correcting. The lower the market goes, the more investment there will be, not only in liquid public markets, but also private companies as well.

One thing I think could be a big mistake is halting short selling. While it seems distasteful to the media and “Main Street” for some ruthless Gordon Gekko-type to profit from someone else’s loss, this is irrational thinking. Short selling a company that ends up going bankrupt concentrates cash into the hands of the short sellers where at least it has a chance of being deployed meaningfully very quickly into equities and other value drivers. Without short selling, that value gets dissipated and does nobody any real good. We’ve heard recently of David Einhorn making a fortune on the short side, and we can be pretty sure that that money will be back in action at least partially on the long side very soon.

As an aside, naked short selling is bad because it’s a credit shell game (back to what got us into trouble). The uptick rule may be a good thing because it prevents unnecessary volatility and self-fulfilling panics.