Having considered whether recapitalization is the better solution for banks in the last post, the mortgage-backed security (mbs) exchange alternative warrants a look.

Using an improved and efficient RTC model, where federal funds are used to purchase the mbs’s (and foreclosures) at current market value (i.e. 15 or 20 cents on the dollar), you can then create a transitional marketplace where the mbs’s have genuine value, based on the amount of the security that is performing.

At the federal level, you establish a legitimate valuation model to first get selling price to the investor. This includes federal backing if the mbs goes below a performance level that is agreed to in the purchase contract (e.g. sell at 50 cents and feds guarantee all losses below 30 cents for 3 year period).

Sell value would be based on percentage of the security that is performing and estimate of any erosion in that performance. Sales have the benefit of taking place orderly because the US holds the instrument and takes the performing cash flow until buyers come forward at prices that are reasonable for a disposition process.

This approach seeks to unlock the value that exists within the current worthless value assigned to mbs’s. It’s a significant action because it takes hundreds of billions of dollars that are currently receiving a $0 value on balance sheets and reintroduces them as a viable source of cash flow to investors.

It’s getting “bailout” money from the asset you are bailing out. It does not use federal debt backed by taxpayer funds for other than bridge financing and it puts large, accretive money into circulation, while recovering the feds investment. You wind up getting a real 3 or 4 to 1 multiplier effect by taking a worthless asset off the balance sheet for 15 cents/dollar and getting it to produce cash flow in the economy at 50 cents/dollar or higher (as the market develops for mbs’s again).

The Feds/taxpayers will bear the risk of non-performing mbs’s whether they are left on the balance sheet at $0 or bought with the intention of creating a market for them. It makes good sense to actively get involved and make the market. It’s making lemonade from lemons.

Securitization is going to have to return in some form and work, prospectively, if there are going to be global markets. Packaging standards are going to have to be like food labeling and be well mapped to the underlying borrower and assets. Recourse risk will have to exist for those who package and label negligently or not in good faith.