Today in the Wall Street Journal, Peter Wallison of the American Enterprise Institute proposes the Treasury purchase bank’s troubled assets at their net realizable values. Currently, these assets are priced at market value, which is below their net realizable value. (See diagram below.) Although there is a risk that the taxpayer might pay too much for these assets by buying them at net realizable value, the benefit is that these purchases would help to boost bank’s depleted capital. This in turn, should “eliminate doubts about banks’ solvency and free up their ability and willingness to lend again”.

I agree with Mr. Wallison’s assessment. To restore liquidity to this market, I believe the government should not only buy the troubled assets, but also sell derivatives related to these assets. As the article indicates, there is a liquidity problem, and hence a pricing problem in the market for these assets. If done correctly, the taxpayer might even profit from this approach. As a nation, we’ve socialized the debt anyway, so any losses the taxpayer might incur under this scheme would probably be less than the current plans.

How might this work? As the government, I would require the banks to sell, say 20-40%, of their troubled assets at their market value. Simultaneously, the banks could purchase put options on the assets at their net realizable value. These put options would, of course, be written by the government, offering protection against further losses. Thus, the banks are protected from further losses at the net realizable value. This would inject capital into the banks, limit the down-side of the banks, and help to generate liquidity in the market.

Additionally, the government could write call options against the assets they purchased. If the banks are confident that the assets are worth more than the market values, the banks could benefit from the upside potential of the options. The taxpayer would receive the premium from the options. Again, this would help to create liquidity and allow private investors (such as private equity) to buy these distressed assets.

This is not to say that only the banks benefit. The government does not have to sell call options against their entire position. They might only sell options against half their position- or just enough to make a market for the troubled assets. This would allow the tax payer to benefit from the increase in their market values.

Finally, the options could be written with various expiration dates allowing more time for the banks to repair capital through their daily operations.

Like Mr. Wallison, I believe suspending or eliminating mark to market accounting would allow the banks to carry these troubled assets indefinitely, which will paralyze the banking system for years to come. (Can you say Japan?) I readily admit that I am not intimately knowledgeable about this market or the bank’s troubled assets. But, I feel using options on these assets would provide policy makers and the market a lot of opportunities to restore liquidity to these frozen markets.

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