It isn’t the amount of money to be spent. While $700 Billion Dollars is not chump change, re-capitalization of the banks and other financial firms holding these assets is a real necessity of we are to avoid more bank failures.

No, the primary issue is whether that bailout money will be spent in ways which overvalue the price of the mortgage backed securities and other derivatives purchased (i.e., the buy high strategy) or whether it will be employed to purchase these securities at a price that more accurately assesses the risk to the seller who takes ownership of these debt instruments (the buy low strategy). Unfortunately, the fear is that any purchases by the current administration’s financial team (Treasury Secretary Paulson and Federal reserve Chief Bernanke) will incorporate the former approach as opposed to the latter.

If the question is whether or not to buy something, like the $700 billion in mortgage securities to be bought in the plan, shouldn’t the question of how much you’re going to pay for it be a major consideration? […]

It’s the same thing with mortgage-backed securities. The $700 billion can be spent to buy lots and lots of them very cheaply, or much fewer of them priced higher. Whichever option is chosen will critically determine whether we’ll soon be able to see the breaking of the dawn out of the current darkness.

Treasury Secretary Henry Paulson and Federal Reserve chairman Ben Bernanke have been playing this issue pretty close to the vest, but through leaks and the likes it looks like they’re going to be buying high, paying as close to par value* on the securities as feasible.* […]

What’s the current problem with the world financial system? … [T]he banks and other financial institutions … need to be “recapitalized”; they need to get back what the deleveraging beast is currently destroying.

Will paying higher prices for MBS accomplish that? It will, at least temporarily for whoever is lucky enough to get a piece of the government action. But for the system as a whole, the benefits are a lot more questionable.

It is estimated that there are about $5 trillion of original securities created out of US mortgages – $700 billion gets you 14% of those, about what is to be expected to be the high-water mark for US homeowners defaulting and being foreclosed in the near future. […]

Essentially ignored in all this is the probable trillions upon trillions of leveraged structured finance derivative securities whose value depends on the original securities. Nobody really knows how much of these there are; one estimate put the number at around $25 trillion. You can’t solve a $25 trillion problem with $700 billion. It’s no wonder that Warren Buffet once called derivatives “financial weapons of mass destruction”.

The bailout plan will essentially ignore the derivative securities, thinking that buying up the original securities solves the problem with the derivatives. It doesn’t. Even if Paulson way overpays on his purchases, say, paying 80 cents on the dollar for securities going in the private market for less than 30 cents, many of the derivative securities were always priced for full payback, so a big problem still remains in a very big market. […]

There are two separate dragons breathing down fire on the world financial system. One is de-capitalization, the fact that loan losses are driving down banks’ capital bases and then their ability to lend. The other is deleveraging, the vicious circular process whereby losses on old loans restrict the system’s ability to make new loans, which drains the system of new capital, setting up yet another round down.

These phenomena may seem similar or identical, but they’re not. Paying up for MBS may seem to recapitalize the banks, but without slaying the deleveraging monster the new capital will surely be sucked away and lost, as has happened to the numerous failed attempts by sovereign wealth funds and private equity to invest in the financial system over the past year.

What we really need is a radical solution. Complete or partial nationalization of our banking system. Yes, that would wipe out much of the equity of all those firms’ shareholders, but it would restore the ability of the system to finance our economy. This was the strategy employed by a conservative Swedish government when its financial system was in crisis in 1992, and it worked:

A banking system in crisis after the collapse of a housing bubble. An economy hemorrhaging jobs. A market-oriented government struggling to stem the panic. Sound familiar?

It does to Sweden. The country was so far in the hole in 1992 — after years of imprudent regulation, short-sighted economic policy and the end of its property boom — that its banking system was, for all practical purposes, insolvent.

But Sweden took a different course than the one now being proposed by the United States Treasury. And Swedish officials say there are lessons from their own nightmare that Washington may be missing.

Sweden did not just bail out its financial institutions by having the government take over the bad debts. It extracted pounds of flesh from bank shareholders before writing checks. Banks had to write down losses and issue warrants to the government.

That strategy held banks responsible and turned the government into an owner. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well.

As the author of the Asia Times article first cited above, Julian Delasantellis, points out, such a radical but essentially practical, approach to our woes cannot and will not happen until a new administration and a new Congress takes office next year. The current Congress is too divided on both partisan and ideological grounds to accept the “Swedish solution” as a paradigm for resolving our own crisis. Until then, the bailout/rescue plan before Congress is just a stop gap measure at best, a bandaid if you will to halt some of the bleeding until people not addicted to Reaganomics and the Cult of Milton Friedman can assess the situation and choose a solution that isn’t ideologically driven, but based on a pragmatic response to the cold hard facts. Will it buy us enough time until Bush leaves office? Will we elect enough responsible people in Congress who will see that we have to take the hard steps necessary to resolve this crisis, before our economy utterly collapses under the burdens imposed upon it by 30 years of Republican style economics? Will solutions with a real chance of succeeding be chosen over those that merely pile more lipstick on the Wall Street pigs?

All we can do is hope that the answers to all those questions are a resounding “yes.”

* [Editor’s note, by Steven D] “Par Value” represents the original price paid for the security, and doesn’t necessarily reflect the current market value of the asset in question. In the case of mortgage backed securities, no one believes that their par value represents anything close to what they are actually worth.