Under the proposal, the government would seed the creation of these ETFs by providing $10 billion for each category. It would receive shares in the ETF in exchange, and would work with market makers to make those shares available to the market based on demand, eventually recouping some or all of its initial outlay.

(It's important to reiterate that the plan discussed here has no bearing on the existing PowerShares filings, which focus on the relatively liquid markets for senior and super-senior, high-quality RMBS.)

Once the $10 billion worth of ETF shares were created, market makers would be tasked with finding a market for those securities. They would test the market at a given price, and if they didn't find demand, drop the price until they did. At some point, the thinking goes, the tax-free yield and limited principal protection would be enough to entice investors into the space, allowing the market makers (and by extension, the government) to sell out the full $10 billion allotment.

The Stahl Plan

Meanwhile, a so-called "Stahl plan" being advanced by both Stahl and Holderith also calls for the U.S. Treasury, with Congress' approval, to make all interest income from primarily short-term MBS securities tax free (based on specific provisions).

In other words, if the banks agree to make it easier for mortgage holders, the government will make it easier for the banks, by boosting the value of their MBSs by making interest payments tax free. Of course, the government will lose revenue due to the tax forbearance.

Once this change is in place, the government would then suspend the mark-to-market accounting rule until "available public market ... (is) established with proper price discovery." The thinking is that the changes (extending the terms and making interest payments tax free) would eventually boost the value of these securities, encouraging private capital to flow into the markets. Once this new market is established, the mark-to-market rule would be reinstated and bank balance sheets would look healthier.

To help foster the development of this active market, the Stahl plan turns to ETFs to spark trading and private interest in MBSs. The Treasury would create an ETF Committee, supervised by the Secretary of the Treasury and the SEC's chairman, to oversee the development of this market.

The Treasury would decide which banks could participate in the ETF program. It would then set aside $4 billion, which would be used to purchase largely performing, less toxic MBSs from banks. The Treasury would then enlist 10 managers with expertise in the MBS space to manage these assets on behalf of the government. Each manager would receive $400 million worth of the securities, comprising a blend of different credit levels.

These managers could then buy and sell securities to create the most attractive portfolios. ETF shares would be sold to the public, and the money returned to the government, shifting ownership from the public sector back to private investors.

Under the Stahl plan, the government would receive a portion of the expense ratio paid for managing the ETF to offset some of the lost revenue from making the interest income tax free.

Potential Potholes Of ETFs

As attractive as these ideas are, they are not without risks, the largest of which stems from the so-called "creation/redemption" process. This process deals with how new ETF shares are created and destroyed, and it is critical to the proper functioning of the ETF market.

For the creation/redemption mechanism to function well, the underlying securities must be reasonably liquid.

The two ETF plans take different approaches to address this problem. Under the Stahl plan, competitive bidding between different ETF providers would help drive liquidity into the market for the underlying MBS. The banks would be bidding against themselves to create the most liquid portfolios, and so, there would be a live market for the underlying securities.

The PowerShares plan flips that on its head and tries first to drive liquidity into the ETF itself. The key feature of the PowerShares plan is the huge initial funding—$10 billion per ETF—and the government minimum value guarantee.

1 | 2 | 3 |