Face, a bad bank, ring fence, troubled asset relief purchase approach to resolving the insolvency of the financial services sector makes no sense, if it's a one step approach. But if there is a hidden agenda (or a multiphase strategy, to put it more politely), it may be a good first step.
Step one. Buy troubled assets at a fair price. A fair price is above the market clearing fire sale price, on the one hand, but it's below the mark to model carrying value of the 'asset' on the financial institution's balance sheet. In the presence of a willing buyer in volume at a fair price, the accounting justification for mark to model disappears, and all holders of like assets must mark them them to the 'fair price.'
Step two. Marking these assets to this price will blow enormous holes in the balance sheets of any number of financial institutions. It will result in portfolio losses for any number of pension funds, endowments, hedge funds, etc. These will be the inevitable consequences of the 'price discovery' process.
Step three. Manage the resulting insolvency of the regulated financial institutions. In a nutshell, de facto nationalization, but perhaps graded in to dismantle the side bets without bringing the edifice down. In other words, shut down the casino for good, or for a generation, at least, but preserve the utility like functions of the banking system that justify special relief for it in the first place.
Step four. Keep a weather eye out for systemic risk resulting from the stress on other institutional investors--CalPers, the Texas Teachers Retirement Fund and similar entities will have to be monitored, but it's not clear what, if any, assistance they will require.
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