We desperately need a real solution to this banking issue. In my opinion there simply is no "market friendly" answer. There are only solutions that respect the market, and then there are those that attempt to transfer the bad debt - of which there is a lot, to the taxpayer.
The latter cannot be done. Schumer (and Goldman) have it about right in terms of the capital required to pull that off, and the impossibility of funding such an exercise.
Therefore, the only rational answer to this mess is to:
Defang the CDS monster. This must be done now. CDS provide a limited-risk and near-unlimited reward for shorting a firm's credit; this is exactly backwards from the equity markets where shorting is limited-reward but unlimited risk. Short-selling is essential to a balanced market but allowing CDS to be abused to invert the long/short risk profile is outrageous and must be stopped. The proper approach to doing this is to:
A. Force capital adequacy to be proved for all outstanding contracts. If you can't prove the ability to cover the contract, it is declared void.
B. Bar the writing of new CDS on any TARP recipient. The government has said it will not allow these firms to fail. The bets have been made; existing ones that can be covered by the writer are ok, but no new positions can be opened until the government's interest is extinguished in that name.
C. Require that all new CDS be written against a public exchange and direct the ISDA to produce, immediately and nightly until that has taken place, bid/ask/OI on an accessible public interface.
D. Consider barring all CDS that are written "naked" - that is, not against a deliverable bond. There are already-existing means to short a firm you believe is in trouble in the equity, options and futures markets. The inversion of the risk:reward profile in the CDS market is a big part of the problem and we must consider putting a stop to it.
E. Do this all right here, right now. Give market participants a very short term (two weeks, maybe four) to get their act together or face having their contracts rendered noncollectable.
Send in the bank auditors and examiners, suspending all bank share trading for two weeks. Mark everything to the market. Anyone who is insolvent under Tier Capital rules gets crammed down ala-The Genesis Plan. All firms that are crammed down have their boards and management removed; the new equity holders (former bondholders) get to elect new management to run the firms they own without prejudice (if they want the old management back, they're welcome to have 'em, but there is no ability to manipulate the vote by entrenched management!) All firms then re-open for trading at the same time - but existing shareholders (including preferreds) of the "crammed down" are wiped out.
For those firms that cannot survive even when crammed down they are instead seized by the FDIC and RTC'd. This works exactly as it did in the RTC days; the FDIC gets the assets in exchange for guaranteeing deposits, and disposes of them in its self-funded "bad bank." That is a "bad bank" model that can and will work and has no "asset valuation" issues.
Be prepared to use the second half of the TARP funds to either internally capitalize new banks which will then be spun off to the public or add capitalization to existing good banks. The cramdown and receivership of the bad banks will undoubtedly lead to lots of guaranteed deposits and good assets needing a home. There are hundreds of perfectly solid existing banks that should be permitted to grow their asset and deposit base by feasting on the carrion of the deposed.
Start investigating the fraud, and be vigorous about it. The public is not going to sit for their 401ks being destroyed as they have already (and will be as this plays out) without blood. There are lots of bad actors out there, starting with the officers and boards of failed institutions. These were not just "bad bets" that caused our banking system and economic problems - I'm willing to wager that it can be proven that they were knowingly-unsound bets and the mismarking of "asset values" was not accidental either. Down this road should lie plenty of securities fraud charges and maybe more than a bit of Racketeering. Go for disgorgement of the ill-gotten gains to at least provide the people with something to refill the treasury and assuage the anger, along with prison sentences.
There is no "market-friendly" solution to this mess folks. There are, however, disastrous decisions that can be taken, and continuing to hide losses - and the truth - will lead directly to that disaster.
We must deal with the bad debt by forcing it into the open. Transferring it from one pocket to another fixes nothing and if we're not careful we will wind up precipitating a bond market collapse coincident with the stock market melting down to a degree that is several times worse than what we saw in September and October.
Unless President Obama wants to be known as our second Herbert Hoover, he must not allow the game-playing to continue any longer.
Neither you or I want to see the S&P 500 collapse down into the 200s with 75% of the listed firms in this country going under. Nor do we want to see 20 or even 30% unemployment. I'm sure you're not interested in seeing not a 30 or 40% loss in your 401k as you had last year, but an 80% loss. And I'm very, very certain that having the government - both state and federal - unable to raise operating funds and being forced to cut off social services and entitlements is not on your "desirable" outcome list. Yet all of this can and will happen if the bond market dislocates and starts a cascade. The price action in the market over the last couple of weeks is a strong warning that "borrow and spend" will not work and the market is getting rather upset with papering over ever-expanding losses.
It would be nice if President Obama had several weeks or even months to coordinate a strategy. Unfortunately the market doesn't work this way, and it appears that he is being forced to either crap or get off the pot essentially now, lest the market decide for him.