(Originally published at Greater Democracy.)

In my recent posts about the financial crisis our country faces, I’ve attempted to get people to understand a little more clearly how mortgages are traded and from that to look more closely at what the bailout really entails. Let us now look at possible outcomes.

The Treasury Department has proposed spending $700 billion to buy the mortgage securities that are most at risk, in an effort to avert a severe credit crunch. Where is this $700 billion going to come from? How much of it will come in the terms of new debt issued by the government? Are we just shifting around who is lending money to whom? It would seem so. In addition, we are shifting the lending of money to institutions that have made poor financial decisions.

These at risk mortgage backed securities are often called toxic debt or nuclear waste on Wall Street. They are typically described as too complicated for the average person to understand. However, I think some simple explanations can help.

Similar mortgages are gathered together into a pool of mortgages. In the early days, people would by these pools of mortgages, and every month they would get the monthly payments on all of the mortgages, less any servicing costs. Some of the mortgages would get prepaid when homeowners sold their houses and moved, when they refinanced, and in other special cases. Engineers on Wall Street created models to predict what percentage of the mortgages would prepay over time.

They also started stripping the mortgage pools, creating one part that is just the principal payments on the mortgage and another part that is just the interest payment on the mortgage. The value of these new securities would be calculated based on the projected prepayment rates. For high prepayment rates, the securities that were the principal payments would be the most valuable, because the principal would come back quickly. The interest payments would be the least valuable, since there are no further interest payments once the mortgages are prepaid. For low prepayment rates, the opposite holds true. There are more interest payments and it takes longer to get the principal back.

Add to this the ability to bet on the direction interest rates will go and leverage the bets one way or another, with different tax consequences, and you could easily take some very large bets. As the economy weakened and people started having problems making their mortgage payments, foreclosures (and hence prepayments) increased. This also resulted in decreasing home prices which added to the foreclosures.

So, some large institutions have made some bad bets about the direction of housing prices, interest rates and prepayment rates, and now they are in trouble. If we don’t pump $700 billion into these institutions, their difficulties will spill over into other companies that do business with them. On Wall Street, they call this counter-party risk and we’ve already seen some of this in the bailout of money funds by the Fed in response to Lehman’s collapse.

If we don’t prop up the institutions that made poor financial decisions, it will hurt other institutions that are more solid, so the logic goes.

Meanwhile, the FDIC is suggesting some of this money should be used to help homeowners facing foreclosure. These are the homeowners that took out loans on their houses that ended up being more than they could handle. They based their decisions on the belief that home values don’t go down, that they would be able to refinance their loans in the future, that they would get better paying jobs before rates increased and so on.

These decisions seem to make a lot more sense than the highly complicated and leveraged bets that large institutions made. By buying out these mortgages and helping homeowners refinance, we will protect homeowners, as well as the banks that are on the front line and have more to lose by simple foreclosures. However, it does little to address the poor bets made by large institutions. Whether the homeowner refinances, or is foreclosed, it still counts as a prepayment and the large institutions that made bets against such prepayments still lose, leaving us with the possibility of a credit crunch.

Let’s look a little deeper now about what the dangers are of a credit crunch as well as what precipitated the crisis. If we have a credit crunch, there will be less money available for new investments to keep our economy moving forward. We would face the dangers of a larger recession or depression. In fact, while the crisis was caused by the increase in housing prices, the housing bubble, which was caused by easy credit, what burst the bubble was the slowdown in the economy.

So, what would happen if the proposed $700 billion were used in some other way to stimulate the economy? What would happen if it were used to directly invest in companies that would keep our economy moving forward? To put things into perspective, for $700 billion dollars you could give a million people good paying jobs for ten years.

Would that make a difference in our credit crisis, in the job market, and in the housing market? Yeah, I bet it would make a bigger difference than propping up some large institutions that made bad decisions.

What sort of jobs would these jobs be? Well, if $700 billion were invested in jobs that helps our country conserve energy and use more renewable energy, instead of foreign oil, the payoff could be even bigger as we would have a cleaner environment, need to spend less money defending oil rich countries, and become a world leader technologies for the new millennium.

There are plenty of plans on how this could be done. We could improve our communications infrastructure to encourage more people to telecommute and attend meetings online, thereby decreasing the fuel used for transportation. We could improve our electric transmission infrastructure to facilitate the gathering and transmission of renewable energy. We could offer tax incentives to make buildings more energy efficient. There are plenty of ideas around.

Yes, we should think very carefully about how we spend $700 billion dollars.