Ten Steps To Recovery

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In order to resolve this financial crisis, it is not enough to take toxic assets off the balance sheet of the financial institutions. It is also necessary to reduce the debt overhang of millions of insolvent households via a significant debt reduction on their mortgages. That is why I propose the creation of a Home Owners' Mortgage Enterprise--or HOME. Let me flesh out this proposal and its key elements and compare it to the Treasury's Troubled Asset Relief Program (TARP) that, in its current form, has many flaws.

There are 10 steps in my HOME proposal to resolve this most severe financial crisis:

First: As with the Treasury TARP plan, you need to buy illiquid/toxic assets and take them off the balance sheet of banks and financial institutions to reliquefy them and allow new credit creation. The biggest problem here--as this week's debate between Bernanke and the senators showed--is the proper valuation of the price at which the government should buy these assets.

If the government buys the assets at a price that is too high (at a discount too small relative to face value), the fiscal cost will be huge and you massively subsidize reckless bankers and their shareholders. If you buy at a discount that is too high, you minimize the fiscal cost in the short run--but many banks could go bust and the eventual fiscal cost of bailing out the depositors of failed banks could be large.

There is only one solution: Avoid the government overpaying by letting the government have some of the positive benefits of an upside gain in case the banks' values recover after the bailout. You need the government to have some equity in the banks whose assets are purchased by the government. This leads to step two of the proposal.

Second: In exchange for the purchase of illiquid assets, the government gets preferred shares in the financial institutions that allow it to participate in any future upside.

Third: Even if the government gets preferred shares, the banks will need more capital if they are undercapitalized and have not fully provisioned for the losses, which occurred from writing down the assets being sold to the government. So we will need to inject further actual public capital in the form of preferred shares in the financial institutions. (This is what the Reconstruction Finance Corporation did during the Great Depression).

Fourth: The existing shareholders of the banks need to take a first-tier loss to minimize the risks for the government share. How to do that? Start by suspending dividend payments on common shares and possibly even existing preferred shares.

Fifth: Public and private recapitalization of financial institutions unfairly benefits unsecured creditors--all creditors except insured depositors--of such institutions. So, you also need to convert some of this unsecured debt into equity (a debt-for-equity swap). Such a swap further reduces the leverage of the financial system (leading to a lower debt-to-equity ratio for financial institutions).

Sixth: After this crisis is resolved, the banking and financial system may need lower capital than before so as to avoid new asset and credit bubbles. If you recapitalize banks able to lend more, you still need to let other insolvent banks and financial institutions go bust and disappear. Only healthier institutions should survive.

So you need a systematic triage between banks that are distressed, undercapitalized and illiquid-but-solvent. This should be developed once recapitalization occurs from those that are insolvent and need to be shut down. You need to destroy the bad apples to let the good ones--or the sick but curable ones--thrive.

Seventh: As with the Resolution Trust Corporation, the assets of bankrupt banks that are allowed to fail go to the HOME for a workout (debt restructuring/reduction).

Eighth: You need a program like the Home Owners' Loan Corporation (HOLC) for debt reduction of the household sector. Households in the U.S. have too much debt (subprime, near prime, prime mortgages, home equity loans, credit cards, auto loans and student loans) while their assets (values of homes and stocks) are plunging, leading to a sharp fall in their net worth. Households are buried under mounting debt and rising debt-servicing burdens.

When a country (say Russia, Ecuador or Argentina) has too much debt and is insolvent, it defaults, gets debt reduction and is then able to resume fast growth. When a firm is distressed with excessive debt, it goes into bankruptcy court and gets debt relief that allows it to resume investment, production and growth. When a household is financially distressed, it also needs debt relief to be able to have more discretionary income. The lack of debt relief for distressed households is the reason why this financial crisis is becoming more severe, and why and the economic recession--with a sharp fall in real consumption spending--is now worsening.

There are five possible uses of fiscal policy: income relief to households (the 2008 tax rebate); the rescue/bailout of financial institutions (Bears Stearns, Fannie and Freddie, AIG ); the purchase of assets of failed institutions; the recapitalization of undercapitalized financial institutions; and government purchase of distressed mortgages to provide debt relief to households. The last option is the most important to resolve this financial and economic crisis.

Ninth: We need to avoid a situation where the recapitalization of banks and the resolution of this financial crisis lead to another credit and asset bubble. Many things need to be done to avoid this risk but a rapid change of the Basel II capital adequacy ratios to reduce their the pro-cyclicality would be essential.

Tenth: Start implementing--rapidly--a reform of the regulation and supervision of financial institutions in a world of financial globalization.

Nouriel Roubini, a professor at the Stern Business School at NYU and chairman of Roubini Global Economics, is a weekly columnist for Forbes.com.