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David Paul Headshot

Time for Plan B?

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Markets are a confidence game--perhaps trust is a better word--built on the belief that tomorrow will come around and it will be a lot like today. That buyers and sellers will show up. That the rules will be enforced. And most trades are completed on a handshake.

And politics is a confidence game. Despite all the appearances of a knife fight, it is not unlike a trading floor. Deals are made on a handshake, and you are only as good as your word.

Over the past two weeks, the two games are joined and confidence and trust have been sorely tested. The markets remain in a state of suspended animation, while 535 members of Congress seethe. More than anything, the members detest and resent having their backs pushed up against the wall.

Deep down, even with the palliative changes that have been added--an additional $100 billion or so in tax breaks and other new spending--they still suspect this is just a Wall Street gangbang, as the banks have pushed to include credit car receivables and other assets in the grab bag, as the lobbyists swirled around looking for the greatest payday in the history of paydays, and as the CEOs with their homes in the Hamptons called to plead their case.

More than anything, the members cannot abide being told they have no choice.

But the truth is, they had a choice. They could have chosen Plan B.

Plan B would have focused on the underlying mortgages that are the root of the problem, rather than simply bailing out the financial intermediaries. After all, the fundamental problem with the mortgage-backed securities market is the lack of information. With good information--however bad the news--liquidity would return to that market.

More importantly, the key to a sustained economic rebound is the health of the American consumer, and the American consumer right now is buried under a pile of debt. Taking debt off of the bank balance sheets will not solve that problem. The need for liquidity begins at home.

Under Plan B, the Treasury--or Fannie Mae and Freddie Mac under their existing authorization--would identify categories of mortgages according to levels of default risk and asset coverage, and provide a bid floor for each category pending a workout of the underlying mortgages. Congress would direct the HFA and state mortgage finance agencies to work with troubled homeowners to restructure the terms of their mortgages, capping interest rates and, where mortgages are under water, swapping a portion of the mortgage value for an equity share in future sale proceeds. And they could give both FHA and bankruptcy judges the right to recast mortgages in much the way that a bank pursues a workout of a troubled loan to forestall default and financial distress.

While the Treasury and executive agencies worked to support the underlying mortgage market--the source of the problem--the Federal Reserve Bank would do what it does best: provide capital to a banking system desperately in need of liquidity. The Fed window would be flung wide open for the banks and others who did not make bad choices to grab market share from those who did. And the market would do what it is supposed to do. Those who made bad choices would suffer. Those who did not would do well.

There is a lot of money to be made on the hundreds of billions of CDOs that Paulson and Bernanke propose to purchase for $700 billion, once information on the underlying assets is confirmed and asset values can be determined. Under Plan B, however, the Government role would be to reinvigorate the markets, rather than becoming the direct buyer of first and last resort. The real profits would be made by the hedge funds, private equity groups and others that would move in to acquire the now-illiquid assets that are currently being marked to market at levels well below their real value. With aggressive federal action to validate and fix the underlying mortgages, a market for these securities would reemerge, and, with the prospect of profits to be made, every incentive will be in place to find and fix the underlying mortgages.

And if we fix the underlying mortgages, the financial intermediaries would do just fine.

Then we can move on to the real problem of creating a centralized information repository for the $62 trillion of credit default swaps, so that remedial action can begin to unwind what looms as the real toxic risk to the economy.

But at the end of the day, Paulson and Bernanke will likely prevail with their massive plan that we are assured will restore confidence to the financial system. The Senate has now approved the plan, and the odds are that the House will finally go along.

After all, Plan B is a market solution that could take time, and is less compelling as a short-term fix. And in this case the short-term is barely a month before 435 members of Congress get their report cards from their constituents.

Better to cast a vote for $700 billion and blame the Henry Paulson if it fails, than bet on Plan B, even if in the long-run Plan B might be the right choice.

After all, as Lord Keynes famously said long ago, in the long-run, we are all dead.