The Paulson plan, Arnold Kling notes, is based on the clogged plumbing theory:
The mortgage assets are stopping up the plumbing of the financial system, so the government has to buy up those assets to unclog the system.Why worry about the clog in the first place? Because banks have some of these securities, they are marking these securities to market value, which means marking them way down. As a result, their balance sheets show a shortage of capital. To come back into compliance with regulations, they either have to sell new shares of stock (good luck with that) or curb lending. As they curb lending, the economy suffers.
That is why some people say that the solution is to get rid of mark-to-market accounting. Let the banks estimate the “intrinsic” values of their mortgage securities. These values are higher than market values, so that using this alternative accounting the banks’ balance sheets won’t looks so bad. That way, they can keep lending. My problem with that is that phony accounting has a history of keeping failed institutions in business, raising the cost of the subsequent cleanup.
My alternative is to encourage new lending by lowering capital requirements at the margin. Tell banks that loans issued after September 1, 2008, require half the capital of similar loans issued before September 1. Some banks are in such bad shape that even with those lower capital standards they will not be able to make new loans. Fine. You don’t want those banks to grow. But other banks have room to grow, and you want them to grow more than they would under the existing regulations.