Thinking the bailout through

As we beging to debate how we best get out of this mess, and whether we should go with the Paulson Treasurey plan, Senator Chris Dodd's plan, or some other alternative not seen yet, it is important to be firm on the idea of what this bailout is supposed to do.

What is this bailout supposed to do? And can the bailout actually serve this purpose?

Paul Krugman provides a capsule analysis of the crisis.

1. It all starts with the bursting of the housing bubble. This has led to sharply increased rates of default and foreclosure, which has led to large losses on mortgage-backed securities.
2. The losses in MBS, in turn, have left the financial system undercapitalized — doubly so, because levels of leverage that were previously considered acceptable are no longer OK.
3. The financial system, in its efforts to deleverage, is contracting credit, placing everyone who depends on credit under strain.
4. There’s also, to some extent, a vicious circle of deleveraging: as financial firms try to contract their balance sheets, they drive down the prices of assets, further reducing capital and forcing more deleveraging.

Public intervention is most likely needed, yet we need to make sure that mortgage-backed securities are addressed in this package. If we do not solve any of the issues coming out of the housing collapse, and the devaluing of mortgage-backed securities. If this is not addressed the bailout will fail.

Also the financial system is seriously undercapitalized, causing a credit crunch — and any plan has to address that.

Also public injections of capital needs to lead to greater oversight and intelligent regulation.