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U Chicago prof. Luigi Zingales is unimpressed with the Paulson bailout of the financial sector.

As during the Great Depression and in many debt restructurings, it makes sense in the current contingency to mandate a partial debt forgiveness or a debt-for-equity swap in the
financial sector. It has the benefit of being a well-tested strategy in the private sector and it leaves the taxpayers out of the picture. But if it is so simple, why no expert has mentioned it?

The major players in the financial sector do not like it. It is much more appealing for the financial industry to be bailed out at taxpayers’ expense than to bear their share of pain.

But what good does debt for equity swaps do when the firm is insolvent, and both debt and equity are worth zero?

Also, a warning to those who think "more regulation" is the answer. Financial services is not an unregulated industry, and it this thicket of regulations that gave rise to the complex derivatives we see blowing up. An old post my Mindles Dreck states:

A CBO is just one example of a credit rating-driven transaction, but most of them achieve the same thing - they decrease frequency of loss but increase the severity. So they blow up infrequently, but when they do it's often a big mess. Ratings-packaged instruments are less risky than the pool of securities they represent but often riskier and less liquid than the investment grade securities for which they are being substituted. As a result, they pay a yield or return premium (even net of high investment banking fees). That premium may or may not be enough to pay for their risk. But they pass the all-important credit rating process and are therefore sometimes the only choice for ratings-restricted portfolios reaching for yield.

...[Frank] Partnoy is a former derivatives salesperson, and he clearly suggests that regulation is often the derivative salesman's best friend. Complicated rules encourage complex transactions that seek to conceal or re-shape their true nature. Regulated entities create demand for complex derivatives that substitute proscribed risks for admitted risks. If a new risk is identified and prohibited, the market starts inventing instruments that get around it. There is no end to this process. Regulators have always had this perversely symbiotic relationship with Wall Street. And the same can be said for the ridiculously complicated federal taxation rules and increasingly byzantine Financial Accounting Standards, both of which have inspired massive derivative activity as the engineers find their way around the code maze.

FInally, Krugman continues to demonstrate just how far behind the eight-ball he is.

The Treasury plan, by contrast, looks like an attempt to restore confidence in the financial system — that is, convince creditors of troubled institutions that everything's OK — simply by buying assets off these institutions. This will only work if the prices Treasury pays are much higher than current market prices; that, in turn, can only be true either if this is mainly a liquidity problem — which seems doubtful — or if Treasury is going to be paying a huge premium, in effect throwing taxpayers' money at the financial world.

And there's no quid pro quo here — nothing that gives taxpayers a stake in the upside, nothing that ensures that the money is used to stabilize the system rather than reward the undeserving.

I hope I'm wrong about this. But let me say it again: Treasury needs to explain why this is supposed to work — not try to panic Congress into giving it a blank check. Otherwise, no deal.

The financial system is insolvent, and even if maturity mismatch turns back on (liquidity) the underlying solvency issue is still a problem. To re-capitalize the system, the government needs to take money from those who have it, and give it to those who don't. The Paulson plan does exactly that.