Earlier today, Director of Zacks Equity Research, Dirk van Dijk, CFA, posted an entry called 'A Modest Proposal.'  Since then, a couple senior analysts from the department have issued their responses.

Sheraz Mian, senior oil & gas industry analyst: That's an interesting idea, using the $700B to buy common equity. If nothing else, it completely side-steps the thorny issue of pricing the mortgage-related securities plaguing the balance sheets at present. In a way, it is plain-vanilla version of what the 'Oracle of Omaha' did with Goldman (GS).

They key question, however, remains whether so re-capitalized entities will be able/willing to lend. Wouldn't that take us to where the Japanese banking system was in the 90's -- they were well capitalized, but couldn't/wouldn't lend due to their awful balance sheets. After all, they would still be saddled with a whole lot of toxic stuff on their balance sheets -- difficult to price and get rid of.

From whatever angle we look at this problem, we can't ignore these mortgage-related assets. One way or the other, we need to create a market where these assets can be priced and traded.

Dirk van Dijk: Yes there is still the possibility that banks would continue to hoard the cash they got, but with 49% ownership, perhaps the government could persuade them otherwise.

Rob Plaza, CFA, senior retail industry analyst: As far as I can tell, these plans being discussed still ignore the fact that the crux of the problem is that house prices continue to fall. The proposed bailouts will help the balance sheets of the surviving banks, but none of them do anything to address the declining value of the underlying assets. As Sheraz wrote, the banks may not be willing to lend even with all the toxic paper off their balance sheets.

Why would they want to lend to consumers? Consumers' balance sheets are still overleveraged. Their largest asset (housing) continues to drop in price, while the amount owed remains constant. The government buying the toxic paper does not improve consumers' balance sheets.

A real bailout that actually helps the economy will have to include the government reducing the principal to a level close to current market value of mortgages for homeowners. Those homeowners could refinance the new lower amount. This would help eliminate a huge chunk of problem debt in the system (mortgages that exceed the value of homes) as well as reduce monthly payments. This would allow the consumer to de-lever and clean up its balance sheet without impacting the real economy. With vastly improved consumer balance sheets, banks would have more of an incentive to lend to the consumer.

Of course, there are problems with this type of plan, but we're talking bailouts, for crying out loud. For one, the government would end up eating a lot of bad debt and we taxpayers would end up paying for that. Two, what happens if a homeowner sells his home at a profit above the government-authorized refinanced amount? But this solution beats the alternative: Consumers will de-lever on their own. That means higher savings rates in order to pay down existing debts, more frugal spending behavior, limiting the amount of new debt taken on, and a more pessimistic attitude about how crappy their lives are with all that debt hanging around their necks. This de-levering process will take years, and consumer spending will decline throughout the de-levering process.   

Dirk van Dijk: Part of the problem is that houses are still overpriced and will continue to fall until they reach historical norms based on ratios of both income and the rent on a similar property.  I figure we are about half-way through the housing decline.  The idea of reducing the principal and/or modifying the interest rate could be handled in Bankruptcy court, but that proposal has been blocked by the Banking lobby and the GOP.  I agree that it is a good idea.  Bankruptcy courts have the latitude to adjust principal and interest on every form of secured lending EXCEPT the mortgage on a primary residence, including second homes.  The homeowner would pay a heavy price, namely having to go through bankruptcy, and would not be walking away scot-free, thus reducing moral hazard issues.