Thin Ray of Support for Treasury (see update)
Not to say I trust Paulson, but one part of his bailout proposal potentially makes sense.
Many MBS are illiquid because default rates are totally unknown. The fastest way to restore their liquidity would be to reduce default risk in a transparent way, e.g. write down the principal. This would require voting majority of a given MBS issue.
But ownership of these issues is spread widely. So a fast path to majority would be a Treasury reverse auction on a given issue. Once in control of a given issue, they could write it down so far that anyone would consider it investment grade, which would create instant liquidity.
Such writedowns would reduce the burden on homeowners in those pools, and restore liquidity at the same time.
Would the Treasury actually make money? Hard to say. Kinda doubt it. But if we are truly in a panic, you can construct a scenario: buy an issue at 10 cents on the dollar, write the principal down by half, and resell at 20 cents on the dollar.
UPDATE (9/26/08): A reader points out that purchasing MBS doesn’t entitle the majority owner to modify the individual mortgages, according to this and this. However, those sources also acknowledge that the mortgage servicer can make such modifications, subject to a majority or supermajority vote by MBS owners. So the situation is more complex, but substantively the same, as what I wrote above.
