The most sensible containment plan for the credit crisis - so far.

Senator Charles Schumer just now proposed probably the most sensible containment plan for the credit crisis. He suggested the setting up of an entity similar to the Resolution Trust Corporation during the S&L crisis of the '80s.

The plan calls for the government to set up an entity that will take out the toxic CDOs from the books of the financial institutions, warehouse these securities while the banks re-build their balance sheets and start lending again, and at some point in the future, resell the CDOs to the market.

The most potent force propagating the deleveraging in the financial sector is a crisis of trust and confidence among the banks. Because many of them are holding sub-prime CDOs, they are now no longer lending to each other. And because these CDOs keep being written down, the banks who own them have had to take repeated hits on their capital. With each capital hit, banks have had to sell more assets at lower prices, causing the next wave of writedowns.

George Soros has a term for this vicious cycle – reflexivity. Downturns causing panic causing more downturns. But this panic is actually being fuelled by the mark-to-market accounting rule. This rule forces banks to mark the value of ALL their asset,s based on the clearing price of the last transaction, regardless whether they had planned to sell all these assets at a foreseeable future time.

The planned warehousing of CDOs can do the job of short-circuiting this reflexivity. With CDOs no longer in banks’ books, they will no longer have an asset class with a continuously declining value. They can then focus on re-building their asset base, confident of the stability of their remaining assets.

Who knows, at some point in the future, when we have fully determined how much of these CDOs will really default, a market for them will return and the government entity holding them can sell them at a profit.

So here are my two $64,000 questions: How will the government value these CDOs, and how will it raise the funding to buy them? Senator Schumer plans to discuss the plan in detail later today.

If you happened to be a shareholder of AIG, Lehman, Fannie, Freddie or Bear, too bad your firm didn’t make it till today, before all the value of your holdings went down the drain. Such is life.

Update: Senator clarifies that, unlike the RTC solution of the '80s, his plan does not call for acquiring the pool of CDOs from the banks. It calls for acquiring stakes in the banks, in exchange for taking these out of their books. Therefore, it will be cheaper than an outright buyout of the securities, which do not have an alternate market right now, and hence, have no verifiable market value. The money will come from the Fed's reserves, which he says, is enough to acquire the stakes.

New $64,000 question: How will this change Wall St., now that the government is poised to become a minority stakeholder in practically all the financial institutions?