How did toxic assets become toxic? Who hid the toxicity? Who discovered it?
Assume for a second that you want to buy a used car. That's great because I've got a low mileage 2000 Toyota that I'm about to put on the market. The paint, body and interior are all in great condition. The book value for this make/model/year is $10k, so I'm looking for that price. And, one important thing, I can't let you see it before you buy it, but wait, that's OK because I got an inspection from Al's auto shop and they gave it and A+ grade. You've heard of Al's ... right?
Do you wanna buy it? Hello??
I can't say I know everything about bond or derivatives trading but I know a good deal about troubleshooting. I've got years of professional experience with computers troubleshooting and a fair amount of DIY auto repair. There is something big missing in all the talk about this crises of the century that everybody is panicking about. What are we doing to make sure that we know what the problem is? Are we, as a nation, attempting to test if it will work? There is quite a bit of money on the line. When I walk into a problem, I do this. Get some facts about the problem environment, time line, failure type, and verify the information if possible. Formulate a theory. AND THEN I TEST IT! Preferably, before I go out and spend a stack of hard earned cash on a replacement for the part that likely failed.
This is hard earned experience. Every beginner computer tech will almost instinctively jump in quick succession from symptoms to available knowledge to solution to the necessary exclamation "I know, It must be the __" to implementing a solution. Time is of the essence, but so is getting it right. Jumping to the wrong solution is a waste of time and money. Verify the information that you receive. Research possible causes. Test a solution before implementing it.
But, Bryce, you say, we have the best minds in the country working on this. And that would be, I reply, two very respectable Wall St. veterans Secretary Paulson and Chairman Bernanke who were both executives at the prestigious firm of Goldman Sachs. And that would be the Wall St. that is the center the financial country, at least, if not the world. Has anybody herd of the word Groupthink? Conflict of interest? Good ol' boys? Is anyone so infallible that we should spend $700 billion on their word alone?
We'd better not. We'd better take the time to verify our Billion dollar solution. We're pretty well read around here. From my reading here, Bondad, Jerome, and every popular Paul Krugman have all given some great analysis. Here is a massively oversimplified summary: house prices drop --> defaulting mortgages --> mortgage backed bonds drop in value --> banks fail (if they are holding those as assets) --> banks stop lending--> liquidity problem. So, now we have the government debating a solution to the liquidity problem based on the expertise of two Wall St. insiders. The proposed solution? Give Wall St. lots of money... now. Don't think about it; don't debate; just trust me.
So, What about that used Toyota? Securities are traded based on rating. The quality of the bond depends on the quality of the rating agency and it's grade A, B, C, etc. If we had to buy cars sight unseen, the price of the car would be heavily affected by the credibility of the rating agency and grade. If you haven't heard of Al's Auto shop, the price you'd pay might drop to half of my price. If you have heard a rumor that Al has been taking kickbacks, well... the deal is probably off. The same goes for securities. If you can't trust S&P, who can you trust?
The problem, they say, is liquidity, demand for securities, or to put is simply the amount of credit available to securities banks took a swan dive. Banks stopped lending to other banks. But why? For example, Bank A will stop lending because either Bank A needs the money so they don't go bankrupt themselves, or Bank A does not trust other banks to pay them back, or both. All the debate (lets be thankful that there is debate) in Washington DC is about preventing bankruptcy not ensuring the integrity of the securities. If the first scenario is closer to reality, then the problem will be solved. If the second scenario is closer to reality, then the bailout will not solve the problem no matter how big the checks get.
Lets rephrase the choice from the perspective of our new King Henry: I can get congress to send big checks to my old buddies or I can advocate that we start regulating (which my boss despises) companies that I have implicitly trusted all of my life. Yes, I think Sec Paulson is biased if you cut it like this.
So, here is my test. Are the securities banks that have been taken over by the government able to get loans now that they have the backing of the government? If so, then the problem is credibility because they now have the credibility of the US Treasury. If not, then the problem is liquidity.
But that is just one way to isolate the source of the problem. I'm sure there are others. Why would we commit to a strategy based on guesses?