Paulson Asking Congress for Authority to Buy $700 B MBSs: Congress Should Say No

Paulson and Bernanke have told the public that the administration will draft legislation authorizing the Fed to buy up to $700 billion of mortgage backed securities (MBSs).  The MBSs securities have plummeted in value and jeopardize the balance sheets of the world's banks; the banks are struggling to meet capital requirements that enable them to loan money. AIG, for example, went under and threatened to default on its commercial paper;  the commercial paper market panicked and money fled to treasuries.  Without commercial paper most operating industries in the United States cannot met operating costs (payroll).  Panic set in as Paulson and Bernanke watched the commercial paper market implode on Wednesday.  So Paulsen and Bernanke will "go to the core" of the problem and relieve the world's banks of their rotting MBSs.  Three problems cropped up immediately: 1) Who can sell??  a) The first sub point is which banks are included?  Are United States taxpayers going to bail out foreign banks?  Initially the answer was no -- then yes only if they have "headquarters" in the United States and then yes if they have a "substantial presence" in the United States (which are most all large foreign banks).  Even a no was a problem as foreign banks could sell MBSs to US banks that could then sell to the government (an indirect bailout).  b) Do we leave out American hedge funds and other investment pools when we are including Chinese banks?  It may not matter as hedge funds race to sell to banks that can sell to the government.  2) At what price?? And who decides?  The bill looks to give the FED open ended authority to buy and does not set a price.  The price is critical, of course, and since the United States will be in the market there is no trading market -- the United States, not any trading market will set the price.  If the price is too low and financial companies get an incredible windfall (remember, some companies have recently bought MBSs at huge discounts); if the price is too erratic or impulsive -- not all MBSs are the same -- some companies get unjustified advantages and some get the shaft.  3) Can homeowners now default without penalty??  Once the government holds the MBSs, what incentive to the homeowners have to pay on their mortgages?  Do they have an incentive to default?  Congress is threatening to tie the bailout to homeowner default protections ("we want homeowners to keep their homes").  Moreover, the asset managers in the SPVs that issued the MBSs, with the government owning all the bottom end junk securities in their SPVs may not have much of an incentive to act on defaults that only affect the tranches owned by the US. 

I hope I have convinced you that this is a mess, that the government officials, in their panic, do not seem to be worrying about how whatever system they put in place can be gamed, and it will be gamed, by clever world-wide financial actors.

An alternative solution:  The Fed should buy commercial paper if the market does not, not MBSs.  Let rotten MBSs rot.