The idea is for the government to spend $700 billion in borrowed(!) money to purchase the most worthless mortgage related securities available, the waste so toxic that its half-life will outlast the planet.

This is in turn supposed to inspire nameless holders of large amounts of cash to say, approximately, If the government has bought the paper-that-brings-death, what's left must be worth buying. The government would not have overpaid for the toxins, so I can pay more for the poison still sickening the bankers , and obtain a healthy profit from whoever buys this glowing muck from me. There's nothing better I can do with my cash in a credit-starved business world.

The line of people in very expensive suits waiting outside the banks before dawn in order to be sure to have a chance to buy the paper not purchased by the government will be the day's most unusual news story.

I can see why our elected representatives would be anxious to pass this bill. Especially when improved by unrelated giveaways of more federal dollars. If the bankers can be expected to respond joyously to those who hand them money, the public can be persuaded to be forgiving should the bailout fail. This wasn't a bailout bill, after all. It was a tax cut of which Democrats can be as proud as Republicans.

Panic is said to be loss of rationality in a crisis leading to random actions which might by a sort of Monte Carlo felicity lead to a solution of the problem. Relying on luck when reason fails. The response in Washington to the credit problem can be used in college texts. The course: Psych 101.

Actually, there's a bit more logic to it.

Why are MBS toxic? Because housing prices are falling.

Why are housing prices falling? Because deflationary pressures have overtaken inflationary pressures.

What is the solution? Increase inflationary pressures. And nothing sends an inflationary signal like deficit spending.

Wait! you say. Won't that be just digging ourselves into a deeper hole? No, good sir! Why? Because 6 million people have already been foreclosed on in the last three years. Their credit is ruined, they won't get to play when the housing market is shocked back to life(and no, there won't be a bubble, we're out of soap). Now, the people that sat back and waited will be able to step in and buy on the cheap. The government is done letting asset deflation run amock. That means, time to buy.

the mortgages are not worthless, they are just not worth what the lenders thought they were. saying the government will be spending $700B is also not fair, it's more like the government may assume up to (up to means it may be less) $1.5 trillion in loans for $700B, which is closer to what they are worth.

I don't think the expectation (maybe it's the hope) is that people will see the government buying the bad debt and will start doing the same, rather the goal is to get banks, that won't or can't lend to other businesses because of capitalization issues or fear, to start lending again so the whole house of cards doesn't fall down.

The (appropriate) principle being applied to this mortgage backed paper is, An asset is worth what someone is willing to pay for it. Given the reluctance to buy, the value is currently about $0.

So the government becomes the buyer of last (and first) resort. Its price paid becomes the base for valuing what it hasn't purchased. But if no one is willing to buy at the price set, then what has been accomplished?

A leveraged bank whose assets have become worthless is going to be reluctant to lend. Might not be able to lend, depending on federal rules, though these are now being relaxed. But the key to restoring confidence is still the ability to sell the assets for enough to avoid hurting the balance sheet too badly.

The bailout is an attempt to recreate a market. And my original post considers whether the method decided upon seems reasonable.

They could get a lot more than $0, in fact I would pay them 10-15 cents on the dollar for as much as I could afford, but they wouldn't take it. I would bet there are people with more significant resources who might even offer 25 or 30 cents on the dollar today, and the banks still wouldn't take that. Lehman could have survived, but their CEO refused all offers. Bear Stearns could have gotten much more than the $10B they ended up with, but their CEO turned down all offers. Merrill Lynch, on the other hand, accepted the $50B offer from BofA, because they could see the writing on the wall that Lehman and Stearns were blind to. They were stupid to make or buy those loans, and they are still stupid not to know when to cut their losses.

The assets are not worthless, but somebody with a large capacity for isk needs to start the valuation process. It may end up costing the govt $50 or $100 billion, but that would still be less than a complete collapse.

In God we trust. All others pay cash.

[Title of a book by Jean Shepherd]

Full faith and credit.

That's what the Federal government has, and it's all that guarantees our cash. But even banks have to have collateral, and there are federal rules for minimum assets. Collateral can disappear. Think about what happened to the retirement accounts of Enron employees while they couldn't sell their shares.

Locking in a low value for the mortgage based assets can leave a bank without recourse. Merrill Lynch locked in its loss, and had to be sold. If the assets were worth more than $0.22 on the $1.00, then Merrill Lynch gave away its chance to survive. Selling the company is different from going bankrupt like Lehman Brothers, but the main difference is the availability of a direct federal loan for companies that hoped to wait out the panic.

So I wouldn't expect to see a price as low as $0.22 paid for a lot of the debt purchased by the government. For one thing, it is, as you observe, probably worth more. But whatever it's worth, only the government can announce "I bought toxic mortgage paper" without seeing executives depart unceremoniously.

Maybe the federal actions can eliminate the embarassment. But there may still be other, better ways to use cash available to those who might make a market when credit is so scarce.