In the coming days, Congress may authorize $700 billion to buy bad debt from financial institutions. Even if all challenges of the plan were to be overcome, the plan does not address one of the fundamental reasons why credit markets don't function properly: the under-capitalization of financial institutions. Under-capitalized financial institutions may seek to repair their balance sheet rather than engage in lending activities. If securities are purchased at market value, all the Treasury Department's plan achieves is to provide liquidity to the markets. This is a worthy goal to allow the rolling of debt, but does not guarantee that banks will start to lend again, nor does it provide a floor under the housing market. The plan is fraught with risks that include lower economic activity and a lowered standard of living for all Americans should creditors demand higher interest rates for the sharply growing appetite for debt of the country.

Instead, a capital infusion on the equity side of financial institutions would strike at the core of the problem. Financial institutions employ leverage; any dollar added in equity may be worth ten dollars in lending power or more. Stronger financial institutions would be able to find a market based solution for their bad debt and, simultaneously, start lending again. $700 billion would be more than adequate to recapitalize financial institutions; however, $700 billion spent on buying bad assets may or may not be enough to find a cure for the system.

By providing capital, the government must avoid a critical mistake the Treasury has made in recent months. In recent months, whenever the Treasury intervened - be that in the case of Bear Stearns, Fannie & Freddie (the "GSEs") or AIG, common stock holders were pretty much wiped out. This serves the political purpose of punishing equity holders, but has the disastrous side effect of signaling to the market that anyone providing equity to financial institutions is likely to be severely punished. After all, the Treasury successfully lobbied the GSEs to raise capital this summer, only to wipe out existing common and preferred stock holders a few weeks later. Other side effects of ad-hoc interventions included that commercial banks now have money market funds competing with FDIC insured deposits because of the emergency guarantees under consideration for money market funds. Aiding on the debt side may also be a lose-lose proposition for the dollar: if U.S. subsidiaries of foreign financial institutions receive inferior terms, a capital flight out of the U.S. may ensue; however, if they do receive the same terms, foreign financial institutions have a major incentive to move bad assets to their U.S. subsidiaries. Also importantly, providing capital infusions make the bailout plan less dependent on international cooperation than a bailout of bad debt would require; given that central banks and governments around the world have rather differing views on how to proceed in the current crisis, international cooperation cannot be counted on.

Understandably, the government does not want to reward shareholders whose firms have made bad decisions. At the same time, it is crucial for financial institutions to raise more capital, but capital is scarce. An auction model may be the most suitable compromise: firms that seek capital receive bids on the terms others are willing to inject capital. The government then offers to inject capital (possibly a multiple) using corresponding terms. The private sector bids are likely to be substantially higher if they know that the total capital raised by the firm will be sufficient to bring the firm on a sound footing. The punishment for existing shareholders comes through the dilution created by the market forces of the offering. Whether the government wants to achieve restrictions on executive pay is a political question, but a question the government should then ask as a shareholder, not as a legislator.

This proposal is not without risks, notably we could create a dozen Fannie and Freddie style entities if the government were to seize control of financial institutions. The government should receive restricted stock whose powers and influence are clearly defined; there should also be guidelines established to sell government shares over time by selling them to the public (at which point restricted stocks could be converted to common stock). The Treasury Department would be required to design and publish rules as to when the government would participate in an auction; note that to date, neither the Treasury, nor the Federal Reserve have provided guidelines on when they would interfere in the markets. While this may provide tactical advantages, the lack of a clearly communicated long-term plan may increase inflationary pressures as policy makers throw money at every new crisis that erupts. Any firm that desires to participate in the program should be required to have its books sufficiently transparent to allow for private investors to make bids and make a case as to why a failure of their firm would cause systemic risk. We understand that this solution is also far from perfect as it also raises many questions.

Our preferred scenario would be to allow free market forces play out. We should not throw 200 years of bankruptcy law history out of the window and replace it with a patchwork of new rules and regulation. The unintended consequences of ad-hoc regulations risk destroying New York as the financial capital of the world. The reason the U.S. enjoys this status is because it has traditionally had the fairest rules for all market participants, including allowing for the possibility of failure. Singapore, Dubai and other cities are eager to fill in any void created should policy makers create more harm than good.

However, if indeed a bailout is going to be taken and imminent, we urge policy makers to strongly consider injecting money on the equity side rather than buying bad fixed income securities. It is a political nightmare to manage such the 'bailout portfolio'; and who would be willing to do so? A Warren Buffett wisely declines saying he may have too many conflicts of interests; that comment comes from a man who likely has less involvement in the bad debt under discussion than most in the industry. However, PIMCO is already pitching its services, even pro bono. Of course PIMCO would offer its services for free, as they could lift the prices of all their own debt securities by buying up comparable securities in the market, in the process possibly earning billions.

Of course, the above discussion does not address the second fundamental problem: the fact that home prices remain too high. In our humble opinion, the bailout as currently under consideration in Congress does little to address this. A capital infusion, however, at least provides banks with greater flexibility of finding a market-based solution, reducing, although not eliminating, pressure on policy makers to agree on how to address this.

We manage the Merk Hard and Asian Currency Funds, mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com.