Defects of Treasury's Proposed Financial Rescue Plan

While listening to testimony from Messrs. Paulson, Cox and Bernanke yesterday morning, I realized that there is a better way to avoid the severe consequences of the current mark-to-market valuation about which I, and others, have recently written. As I read Holman Jenkins, Jr.'s editorial in the Wall Street Journal, I saw that he, too, recognized the same opportunity.


Fed Chairman Bernanke was the soul of comprehensible, clear and focused descriptions yesterday regarding valuations of structured finance instruments by both 'mark to market' and economic valuation methodologies. So clear, in fact, as to have likely been comprehensible even to a group of US Senators.

Essentially, Bernanke described the current 'mark to market' values of mortgage-backed CDOs as 'fire sale' prices. The economic, or net present valuations, he characterized as 'hold to maturity value.'

So far, so good.

What is still mysterious is why Bernanke and Paulson need government money to buy these CDOs at bids close to their 'hold to maturity value,' thus providing the distressed current holders, various publicly-held, capital-starved banks, with the valuation difference between the bid and 'fire sale' prices, thus effectively recapitalizing the banks.

Bernanke even went so far as to note that, once a sale had occurred at this new, higher, economic value price, all similar CDOs could use that price to mark their instruments to this new, capital-preserving value.

Problem solved!

If that's all that is required, why spend $700B to do it? As Holman Jenkins also reasoned, if all that is required to provide a new 'mark to market' value is a bid by some other party, then no actual expenditure of Federal money is required.

How about this alternative? Much like the Treasury's note and bond auction to primary dealers, that department creates a mortgage-backed securities trading exchange. Members post collateral, as is common with exchanges. The new exchange offers counterparty risk protection, so it would be reasonable to expect it to attract quite a few members wishing to buy or sell the CDOs.

Next, Treasury posts bids the 'hold to maturity value' for various CDO types, by CUSIP numbers. Holders of these instruments need not sell them. Once these bids are in the market, holders automatically can justify non-fire-sale valuations.

You see, this entire 'crisis' is about near-term distress, versus long-term economic, 'hold to maturity' value. For performing CDOs, composed of mostly-performing mortgages, the economic value is quite near the face value. Only the lack of a current market bid near that level, due to worries of counterparty risk and the opaqueness of CDOs, requires holders to value the securities at capital-destroying values.

If we, as a society, through our governmental institutions, allow ourselves to bid the economic value of these securities in a well-defined market, then 'mark to market' works to everyone's advantage. The economic value becomes the market value, and no securities have to be marked down or sold at distressed values.

Clearly, this is a superior solution requiring a few tens of millions dollars, at most, to form the necessary mortgage-backed exchange.

All the rest of this debate is really superfluous. This entire 'crisis,' was, as I have noted in posts on others' observations here and here, created by a misguided Congressional mandate to use a particular accounting technique of dubious relevance to securities held to maturity.

There is absolutely no need for Paulson & Co.'s proposed multi-billion dollar plan to buy all these mispriced CDOs and hold them for future sale.

Instead, let's just form an exchange wherein we can, through our government, create a continuously-priced market, via government bids, for the securities which, today, have no existing market in which to trade or be priced near their economic value.