10/25/2008 05:12 am ET | Updated May 25, 2011

It's the Liquidity, Stupid: Why Not Put the $700B Into Good Banks?

The Paulson proposal to purchase mortgage-related assets (MRAs) focuses entirely on the health of distressed banks. Presumably, the government will pay above-market prices for the MRAs, perhaps doing terminal value analysis with a discount to present value, and paying that inflated price will improve the banks' balance sheets (assets vs. debts) so that they can lend money. Otherwise, we are told, the banks' assets vs. debts is too thin to support additional loans no matter how good the creditor might be.

I confess that my initial focus was to analyze to the Paulson proposal itself. "Treasury Bailout Proposal: Zero Pain for the Perpetrators, Toxic to Taxpayers", September 21, 2008, focused on the impropriety of financial institutions valuing assets of others when they themselves had similar assets so that an inflated valuation of the other's would serve as a "comparable" in valuing their own. It is a sleight-of-hand. It also pointed out that the perpetrators of our fiasco would actually benefit.

Analyzing the Paulson proposal, however, is less important than zeroing in on the crisis itself, and thus what really needs fixing.

Paulson wants to focus on the health of the banks that are exsanguinating from self-inflicted wounds. But, there is no guarantee that artificially fixing those banks balance sheets will heal the illiquidity that is the real problem.

So, let us assume we have $700B smackeroos to deploy in the economy. Instead of buying the bad debt at inflated prices from the bad banks, why not use it to enhance the capital of the good banks, whose track-records of lending and risk assumption have been demonstrated.

By improving the capital positions of the good banks, they will extend more credit and facilitate transactions. That is the liquidity crisis that is to be resolved. The government would not have to take on bad debt at inflated prices, and the bad banks holding those assets would have to determine how to work them out.

Liquidity would be restored without sticking the shareholders of this country, its citizens, with mountains of bad debt.