The PowerShares proposal may also allow for cash redemptions, with either the issuing bank and/or the government standing behind the offering and willing to redeem at NAV as the "buyer of last resort."

Another issue is that in order to function properly, an ETF has to have both an intraday indicative net asset value or iNAV, and an end-of-day NAV at which creations/redemptions can occur. These NAVs reflect the value of the underlying securities. But part of the problem with toxic MBSs is that they do not trade actively and thus their value and price are difficult to discern. So the question becomes, how do you create NAV for a fund whose securities don't trade very often? No one knows what they're worth!

If this sounds redundant, it's because it's a classic chicken/egg problem: You need ETFs to create liquidity and generate accurate pricing in the MBS, and you need the liquidity and accurate pricing in the MBS to support the ETF.

The hope, again, is that the offer price on these ETFs can be adjusted lower by the market makers until they find an appropriate price in the marketplace, one that will engender demand.

A Third Possibility

As attractive as the two ETF possibilities are, a third avenue presents itself: What if ETFs could be used inside the PPPIP structure? A few tweaks might be necessary, but it's not inconceivable, according to an in-depth analysis led by IndexUniverse's Matt Hougan and Dave Nadig.

Here's how it could work. The Treasury would pick an ETF manager as one of its five targeted managers for the Legacy Securities Program. The ETF manager would be tasked with raising significant seed capital to jump-start the ETF. Once the money was raised, the Treasury would match the ETF one-for-one.

Under the PPPIP plan, the government is also willing to loan money to private managers to allow them to leverage up their exposure to the market. In the Hougan/Nadig plan, this loan money would be held in reserve to facilitate cash creations/redemptions in the fund. This would solve the problem of how the ETF would stick close to its NAV.

The plan would require a few changes from the existing PPPIP program—among other things, investors would be allowed to trade in and out of the ETFs at will, in contrast to the three-year lockup in the PPPIP program—but it would use the same general principles and create similar levels of risk for the government.

Can An ETF Plan Really Work?

It's entirely possible that the problems with these platforms are unsolvable and that there is too much risk to follow through and launch an investable asset. It's equally possible that the concept of integrating ETFs into the PPPIP structure is too difficult.

But the concept of using ETFs to solve a major financial crisis is not new. In 1998, in an effort to stem a panic in its equity markets, the Hong Kong government turned to ETFs. It partnered with State Street Global Advisors Asia Ltd. to form the Tracker Fund of Hong Kong. It remains one of the most popular ETFs in Asia to this day.

Proposals have been floated to create traditional mutual funds as a way of allowing everyday investors to participate. But traditional mutual funds come with their own problems: They would be priced once a day based on the issuer's evaluation of the net asset value of the securities, which, as discussed, is highly subject to debate.

And because mutual funds do not provide any real transparency into their holdings, investors would be left relying on the bank to make fair evaluation of NAV. It's a risky proposition for investors, to say the least.

ETF-based solutions would tackle the problem with transparency, while still allowing all investors to participate in the upside. And if they worked, they would drive liquidity directly into the underlying securities in a way that mutual funds do not.

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