My Bailout Plan

Government intervention should provide liquidity, not coverage of losses. Institutions ought to remain liable for their own poor decisions, while receiving stretching out the time available to absorb those losses.

So why buy these things at any price? Accept them as collateral for loans, with maturities equaling that of the collateral. The loan notes should carry covenants forbidding any payouts to equity (dividend or repurchase, common or preferred). Cash compensation to management should also be capped. Large asset purchases for cash should also be forbidden. I'd like the government's position to be senior to all other obligations, but perhaps this is legally difficult, and might forestall further financing. But the idea is that no cash leaves the borrower to its equity or management until the government has been made whole.

I don't know how to price the collateral. "Market" levels don't really exist, and would force the banks to take the losses that cause the problem to begin with. Par levels would expose the government to borrower counterparty risk. I think you go with the latter, as the point is to create space to work out the losses while restoring liquidity.

Won't this constrain credit expansion as equity is dedicated to working out from under the government note? Yes. But credit ought to contract anyway. As credit rates rise, institutions will see advantage in building up loan portfolios rather than repaying the government. And they'll have the liquidity they need to operate and lend. At the same time, they'll have incentive to repay the notes.