October is supposed to be the month when the big blowups happen. Oct 1929, Oct 1987, Oct 1998 spring to mind. Add Oct 2008 to the list.
There is one way in which $700 bn can be used to just stop all this in its track. The average price of a US home is about $200,000. So, $700 bn can buy 3.5mn homes. There is an inventory of 4.7mn homes in the US currently - a 11 month supply at current sale pace. If I remember correctly, 5-6 months of inventory is considered more normal. So, if the US Treasury were to indeed take 3.5mn homes off the market, in one fell swoop it would have taken care of the inventory overhang depressing house prices. As US house price stabilize, investors can then better calculate the value of a mortgage backed security and all the other alphabet soups (CDO etc). You might indeed have a rush to buy these distressed securities.
Now this is going to massively distort the markets in unforeseen ways for sure. But who knows what the current plan ends up doing? The job is to use $700bn to stabilize the financial system, and I can't figure out how buying MBS and CDO's will encourage banks to lend, if real estate prices keep falling because of the inventory overhang.
People are talking about nationalizing banking - why not nationalize housing?
The entire problem lies in the way inflation is defined. If one were to include asset price inflation in calculating inflation, Fed would have been forced to raise rates much earlier in 2003-2004, which would have prevented this huge housing boom.