Today is Day 6 of the “New Trade”: the death and rebirth of the financial system as we know it. Every single day this week has brought things that no one working today has ever seen before. Yesterday was no exception

It was a day of unprecedented volatility in the credit and money markets. The prices of short-duration Treasury securities traversed ranges that are usually seen across entire interest-rate cycles. In a single day.

The stock market, which started the day about 900 points below its level of a mere week ago and kept falling, suddenly turned euphoric and rocketed about 600 points from the low that it reached at 1pm EDT.

What happened to change the mood? Henry Paulson announced that he and Ben Bernanke are planning to construct a government entity that will take ownership of much of the “bad paper,” or distressed securities, from Wall Street.

In essence, they’re planning to save the free market system by killing it.

It was just what battered, exhausted, shell-shocked and weary traders wanted to hear.

Let me tell you a few things about it…

Henry Paulson is the lame-duck Treasury Secretary whose final three months in office will permanently change the world we all live in. What did he do this time?

Along with Fed Chairman Ben Bernanke, Paulson is hammering out a multipart proposal that would create a government-owned entity to acquire large amounts of the distressed mortgage-backed securities that are currently poisoning the balance sheets of banks, Wall St. firms, and others.

The entity, a “bad bank,” would possibly be structured something like a hedge fund, or like the $30 billion vehicle that the Fed created to hold MBS taken out of Bear Stearns.

There is also a proposal to step up the Treasury’s direct purchases of MBS in the open market. (This is actually an acceleration of one of the features of the Fannie/Freddie takeover.)

But it’s the first thing, the new national “bad bank,” that we have to understand and concentrate on.

Paulson spent the evening on Capitol Hill, briefing key lawmakers and staffers about the proposal, which won’t appear in draft form until early next week. It will probably require emergency legislation.

Congress will either vote on the proposal before they get out of Dodge on September 26 to go face the voters, or else they’ll give Paulson permission to do his worst while they’re out of town. The possibility of coming back to DC for an emergency session after Congress adjourns was also raised.

Paulson and Bernanke need to get two critical things right about the new “First National Bad Bank of the United States”: the price and the covenants. And there are powerful opposing reasons to go one direction or another on these.

If they’re proposing to go to Wall Street and everyone else in the shadow banking system, and put down a bid for their mortgage-backed securities, what will the price be?

There is no liquid secondary market for MBS. Like the vast majority of debt securities other than US Treasuries, people bought them with the intention of holding them to maturity, not to trade them. So there’s no reliable market price. No one honestly knows what many MBS are actually worth. If you define current market value as whatever someone is willing to pay today, then the answer is effectively zero, which obviously is far too low.

The First National Bad Bank of the US can’t offer to buy MBS at par, or face value. These securities have already declined in value because of the increase in the rate of home mortgage defaults. The people who originally bought the paper must take losses. Otherwise the Treasury is rewarding everyone for making a horrible investment decision. This would create enough moral hazard to swamp the entire financial system.

On the other hand, they can’t force everyone to take a huge haircut. Depending on how big a loss you force people to take, it could impair everyone’s capital for years to come. And that doesn’t fix the credit crunch.

The answer is somewhere in the middle. Let’s be extremely clear about this point:

The role of the First National Bad Bank of the US is to set a price in the MBS market. The government is going to do what the market was unable to do, which is to value these highly-illiquid securities and make them tradable again.

We always say that markets are good at setting prices because they process information so efficiently. This is a case where there is no information to process, so there’s no market, and the government will have to set a price using a completely unconventional method.

They’ll construct elaborate computerized valuation models, incorporating inputs from historical prices and from stochastic analysis. That will take a lot of time and computer cycles. At the end of that process, someone will stick his finger in his mouth, hold it up to the breeze, and write down the first number that pops into his head. That will be the price.

And whether that price turns out to be correct will determine whether the credit crisis will end, or whether we get a massive asset deflation that would trigger a crash in the real economy, with reduced output, job losses, and all the rest.

Not too much pressure, is it? Paulson can handle it.

In economic terms, the effect of this is to reflate the economy. The system is in distress because of the capital losses on MBS. There is no current market for MBS, so their value is effectively zero. But the First National Bad Bank will artificially create a value that is far above zero.

This is precisely identical to increasing the size of the money supply by printing new money. It’s inflation. The Treasury has said that they expect to finance the Bad Bank’s purchases of MBS by issuing new Treasury debt. Maybe half a trillion dollars’ worth of new debt.

There’s no way to sugarcoat this. It’s as if you went to the track and you lost money, and your rich uncle gave you an amount of Monopoly money equal to what you lost. (Minus a discount, just to teach you a lesson.) Except that the Monopoly money can buy stuff just like real money can.

This is where the covenants come in. The government is providing something of value to the people it will buy MBS from. What will it take from them in return? I don’t know the answer to that question.

Maybe they will be forced to fund the purchases themselves at some penalty rate of interest. Maybe they will be forced to submit to onerous regulatory restrictions on their future behavior. This is a big question mark that Paulson et al will need to fill in over the next few days. They certainly can’t get this for free.

Now what happens to the First National Bad Bank? Well, how long does an MBS last? Usually about five to seven years. That’s how long it will take for the Bad Bank’s portfolio to run off. As the paper matures, the Bad Bank will automatically self-liquidate.

Remember I said earlier that your lenders won’t allow you to hold positions on which you’ve had capital losses? That’s not a problem for the Bad Bank. They will be able to hold the distressed portfolio to maturity.

That’s the essence of why the Bad Bank is a good idea. It’s basically paying off the financial system’s margin call, so everyone can get back to lending money for business again.

What would the risk be? Well, if the Bad Bank pays too much for the portfolio, we risk a massive and destructive inflation. That’s a real danger.

And if they underpay? Well, then we’d risk a deflation, which would be vastly more destructive. (It would be Great Depression II.) They will err on the side of overpaying.

There are two key side effects of overvaluing the systemic MBS portfolio. One is inflation, which we will certainly get. We know that going in. Inflation, interestingly enough, is a cost that can be largely defeased by handing it off to the rest of the world, which has shown almost no diminution of its desire to hold our paper.

The other side effect is moral hazard.

And the only way to control moral hazard that is created by government, is for government to control the subsequent behavior of the beneficiaries.

We will see in the next few years a pulse of financial and economic re-regulation that will be as large as the New Deal. Possibly even larger.

In a very meaningful way, ladies and gentlemen, free markets in the United States will come to an end. We will have killed the system in order to save it.

-Francis Cianfrocca