House GOP Alternative

Here is the first detail on the House Republicans' proposal.

Here is how they would fund coverage of the mortgage assets:

"...any rescue package should adopt a plan to insure mortgage backed securities (MBS) through payment of insurance premiums....However, rather than taxpayers funding the insurance, the holders of these assets should pay for it. The working group’s proposal would direct the Treasury Department to design a system to charge premiums to the holders of MBS to fully finance this insurance."

I don't see how this works on a post facto basis. Insurance spreads risk across a group. Included at the start, cash flows include a cushion for insurance premiums which makes an excess available for shortfalls. After the fact, the whole problem is that cash flow falls short of expectations. Paying insurance on Security A requires taking cash from Security B, which reduces the value of Security B. And there can't be any more insurance than there are payments, so nothing can actually pay out at par. This spreads out the risk and diversifies particular securities, but that actually punishes anyone who was careful about their purchases in the first place.

What if the insurance just provides a floor and insures just (say) 50% of cash flow? That might be doable, as there should be cash in some securities in excess of the floor. But it is still just spreading the pain, and punishing the careful still more as a portion of their securities' cash flows to those below the floor.

And how would this handle complicated instruments like IO strips and Z tranches? These are priced in part on the risk of default (which pays out principal but stops interest payment) and on assumption of first loss risk. Would these be insured? Why should they be?

I don't see how this can solve the problem.

The proposal does suggest recapitalizing the system with tax breaks and dividend freezes. This isn't a bad idea, but there isn't any reason that the government should get these taxes foregone back, with interest, before the banks resume dividends.

I think this process needs more ideas.