03/17/2008 10:50 am ET Updated May 25, 2011

After Bear Stearns: Brady Bonds?

The Fed over the weekend made its intervention. Back on November 8, 2007 clouds were forming that presaged this move. Bank announcements of billion-dollar writeoffs to cover subprime losses were disconnected from analysts, such as one at the Royal Bank of Scotland, saying that the full extent of the losses would be much larger, more like $250-$500 billion.

Fed Chairman Bernanke testified then to Congress then that he expected both slower growth and higher inflation (stagflation?), but it would be temporary. Leading to the question: "How long is temporary?" The Bear Stearns crisis on Friday and its takeover by JPMorgan Chase clarifies the situation. The RBS estimate may be on the low side. Temporary may be longer than we expected. The initial bailout offering from the Fed on March 11 of $200 billion for banks was not enough. Bear Stearns owed too much money to fail. A direct intervention was needed.

The members of the Federal Open Market Committee are expected to lower the Fed funds target rate tomorrow (March 18). But that's not going to make much difference as no one knows which bank might be next.

Perhaps marketplace liquidity could be revived by Brady bonds. When Nicholas Brady was Reagan's Treasury Secretary in 1989-1993, he faced debt defaults in Mexico and other developing countries as the U.S. recession reduced demand for imports. Brady provided these countries with a form of U.S. government insurance for replacement bonds. Loans that had defaulted were converted into bonds collateralized by zero-coupon U.S. Treasuries, ensuring that principal would eventually be repaid. Investors gambled only on the payment of interest and the intermediate marketability of the bonds. The Brady bonds had maturities up to 30 years and coupons with a choice of rates (fixed, variable etc.). They were a success. Mexico issued its first Brady bonds in 1990 and within three years the defaulting countries were back in the debt market.

The Brady bonds worked then. Could they work again today to restore liquidity and make unnecessary further direct interventions by the Fed?