The emergency meetings at the NY Fed to try and find a way to rescue Lehman have not yielded a deal yet and frankly, if I was sitting at that table representing any of the major firms, I wouldn’t do a deal either. It is time we stopped looking at this as a piece-meal job. Until we come up with a universal solution, this will just continue and serial emergencies is no way to run an economy. As a committed libertarian, it is tempting to just say to hell with it and let whoever is going to fail get on with it. But as someone with a stake in the financial system, I would prefer to see some kind of solution that is broader in scope.

One of the problems that should be addressed immediately is mark to market accounting. The idea of mark to market was admirable; make the balance sheets of these big financial institutions more transparent. The reality is somewhat different. As asset prices rose and assets on the balance sheet were marked up, insititutions leveraged up. Now the process is working in reverse; as asset prices fall, assets on the balance sheet must be marked down and leverage decreased. That process needs to end and there are only two ways to do it. Either the assets (primarily real estate) need to stop falling in value or the financial institutions need more leeway in when markdowns are required. The former may be happening already so why not give it time to see what these assets are really worth?

Here is the outline of a plan:

1. There has been a lot of talk about the “good bank/bad bank” model for Lehman in which bad assets are roped off in a seperate company while the rest of Lehman goes about its business. Why not expand this to any financial institution that wants to participate? Set up a “bad bank” to which any of the players can contribute bad assets and capital. In exchange, require the investment banks to submit to capital requirements like the commercial banks.

2. Allow the “bad bank” to maintain its balance sheet by valuing the assets at current valuations until the assets are sold and the price known. You need a mechanism to prevent banks from contributing things they’ve valued too highly so, losses need to somehow revert to the contributing bank.

3. Reform the accounting rules so that this doesn’t happen again in either direction. If the banks hadn’t been able to mark up and get more leveraged we wouldn’t be in this mess.

4. Give the “bad bank” a sunset date. The goal should be to liquidate these assets in an orderly fashion instead of a fire sale. Give it 5 years with an option for 2 more.

5. Reform the ratings agencies so that they are responsive to the buyers of investments rather than the issuers.

This is just an outline and I’m sure there are plenty of problems with it. If you have better ideas or can expand on this outline, please comment.

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