This is my understanding of the financial crisis, and a suggestion for resolution.
The basic understanding is that the entire network of mutual obligations represented by the advanced derivatives is a cancer that is superfluous to the functioning of the economic system, but can potentially completely disrupt it. Hence it needs to be isolated and removed.
This is the core proposal:
* Freeze the worldwide secondary wholesale instruments market (CDS, CDO and other advanced derivatives). Build a firewall between this part of financial institutions and the other parts (retail and primary instruments).
* Address the liquidity impacts on the retail and primary wholesale (stocks, bonds, options etc.) parts of the financial system through Government loans (in anticipation of a full buyout) against the assets represented by the secondary wholesale instruments.
* Unwind the advanced derivative position (over months) on paper. Settle the positions against the loans (after the system stabilizes). This will cause some institutions to fail – allow them to do so. Some will also fail in anticipation of the unwinding. But building a firewall between the traditional economic system and the securities market (which is frozen and eliminated) will eliminate domino effects and prevent a global meltdown.
This is effectively the same as “buyout of the securities”, with loans pending final settlement. But it adds firewalls that prevent securities from absorbing the liquidity being pumped in, and eliminates moral hazard.
Reasoning after the jump.
Thanks to Texas Gray Wolf for his feedback on a seed version of this. I am including his feedback as the first comment.