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Build a better bailout

The Paulson plan should target bad loans, not burned investors.

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Desperate times may call for desperate measures, but that didn't stop Treasury Secretary Henry Paulson's plan from getting a chilly reception in Congress this week. Senators from both parties assailed the $700 billion bid to restore confidence in financial markets, declaring it unacceptable. "We have to look at some alternatives," Sen. Richard Shelby of Alabama said.

The good news is that there is a very promising alternative to consider – one that could be grafted onto the Paulson plan. It represents a much better investment of $700 billion, it's been used successfully before, and it would help troubled homeowners more directly.

At the heart of this crisis lie two sides of the same coin: Heads are the bad home loans. Tails are the toxic securities that financed these mortgages. The former is what's pushing many homeowners into foreclosure. The latter is what's sinking Wall Street.

The Paulson plan primarily deals with the tail side of the coin – the investors who got burned handling hot subprime securities. A better plan would start with the head – the bad loans themselves.

The Treasury Department's chief strategy is to buy back large quantities of toxic mortgage-backed securities. These purchases would remove troubled assets from the balance sheets of selling institutions, and (hopefully) clarify the prices of similar securities held by other investors.

How this price clarity would come about is unclear. Will the government's purchases be considered accurate measures of market value or merely fire sales by frantic firms facing bankruptcy? The ownership of underlying mortgage pools will still be highly fragmented. The mere shifting of ownership of large quantities of securities may do little for price discovery, and could serve simply to transfer government resources to selling institutions.

A more effective strategy would be for the government to target the source of the toxicity by buying actual loans, not the securities that back them. It could do so by taking ownership of entire mortgage pools, starting first with the lowest quality (and most toxic) ones.

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