All the Fed's alphabet soup of emergency liquidity facilities innovated over the past year were structured around repurchase agreements. Toxic waste securities were used as collateral for US Treasuries and dollar credit at 85 percent of face value. But as each facility expires, it has to be rolled over and increased to keep pace with the implosion of credit in the interbank markets.

This is correct. The Fed and the Treasury have misidentified and mischaracterized the nature of this crieis from the beginning, equating it to a garden variety 'money panic/liquidity squeeze'. Under such circumstances, the injections of Fed liquidity would be 'mopped up' after the panic had subsided ... and the Fed's balance sheet cleansed. In a money panic situation, the paper taken as collateral by the Fed in an open market operation would be good, but temporarily undervalued by the panic.

This crisis is a secular revaluation of assets. The paper taken by the Fed as collateral isn't good paper mis-valued ... it really is bad paper! After a year of crisis and bear markets in all forms of paper collateral ... the Fed's balance sheet is a mess.

A giant problem with the Paulson proposal is it will bring more bad paper out of the woodwork. $700b now, $1.2t next week, $5t the end of next year ... it will never end. All the banks - both in the US and abroad - are swimming in the stuff.

I disagree with the 'Base Money' scenario since it is an inflation plan. The Fed has plenty of subsidiaries - Fannie Mae, Freddie Mac and AIG come to mind - that can be converted into 'parking spaces' - holding companies for Fed waste. The Fed can replace the waste with more Treasuries and nobody would know. Bernanke could be doing this now, the only concern would be uncertainty over him keeping his job after January.

Restore the dividends for FNM and FRE preferred stock. This will immediately improve the balance sheets of small, "innocent" community banks $ 10 to $ 15 billion.

You have illustrated the core of the current crisis in one sentence! This is the lack of yield in all investments, particularly debt. 'Simple' return is insufficient, requiring excess leverage and complex intermediation. Instead of returns to savings/investments compounded over time with manageable risk, the markets have turned to 'growth' and speculation ... and complexity and intermediation to 'hedge' the unpredictable risk. Unfortunately, the decline of yield has taken decades to manifest itself and will not be solved overnight with a bailout.

The spark for Paulson's Plea was the bankruptcy of Lehman Brothers and the resulting shockwaves felt in the money markets. The common connection between all the failures is the derivatives markets: the CDS market which is leveraging debt downward (think 'Portfolio insurance') and the interest rate/cash flow swaps market. Trading, originating and settlements in these markets should be suspended until someone who has some insights into them can straigten them out. Doing this would calm the money markets and not cost the taxpayers a dime!

Don't visit my blog!

http://stevefromvirginia.blogspot.com/