The FT commentator has a disturbing column about the limits of the Treasury plan. I think he's somewhat pessimistic (not egregiously so, but somewhat). But, as he says, it's not clear we can afford not to be pessimistic.

Also, he makes a great point about the difference between illiquidity and insolvency, which is really the key analytical issue here:

All along two contrasting views have been held on what ails the financial system. The first is that this is essentially a panic. The second is that this is a problem of insolvency.

Under the first view, the prices of a defined set of "toxic assets" have been driven below their long-run value and in some cases have become impossible to sell. The solution, many suggest, is for governments to make a market, buy assets or insure banks against losses. This was the rationale for the original Tarp and the "super-SIV (special investment vehicle)" proposed by Henry (Hank) Paulson, the previous Treasury secretary, in 2007.

Under the second view, a sizeable proportion of financial institutions are insolvent: their assets are, under plausible assumptions, worth less than their liabilities. ...

The new plan seems to make sense if and only if the principal problem is illiquidity. Offering guarantees and buying some portion of the toxic assets, while limiting new capital injections to less than the $350bn left in the Tarp, cannot deal with the insolvency problem identified by informed observers.

That's right. One possibility I ignored yesterday is that people think the long-run value of the toxic assets is, say, 60 cents on the dollar, but, because of the current panic, are only willing to pay 30 cents. The banks can sell at 60 and stay solvent, but not at 30--the losses would be too big. But if the government can step in and provide a little insurance, it may be able to get people to by at close to 60.

I'd like to believe we're facing that sort of liquidity problem. But it's hard not to read the evidence as pointing to insolvency. (In which case the insurance would amount to a subsidy of 30 cents on the dollar, and we're back to asking what the government should get in return.)

Update: Commentor raylward makes the pithy case for illiquidity: 

There are two important points missing here. First, forcing the banks to value the bonds (the toxic assets) in today's overly pessimistic market will render many banks insolvent but will not provide an accurate measure of the assets' true value. The bonds valued at 40% of par today may be valued at 90% of par in a year. Second,  by "insolvent" we are referring to a balance sheet test (i.e., liabilites exceed assets) not whether the banks can pay their bills.  And applying a balance sheet test is this overly pessimistic market makes little or no economic sense.  While I appreciate the gravity of the financial crisis, we make it seem much worse by incorrectly identifying the real issue.

Again, I guess the response is that it's certainly possible. But can we afford to be wrong about this? As Wolf points out, if you assume insolvency and end up being wrong, the worst you end up with is a lot of overcapitalized banks. If you assume illiquidity and turn out to be wrong--well, it gets ugly.

Also, the reason a balance sheet test is more important than a paying-their-bills test is that the point of having banks is to extend credit. A bank that can pay its bills but won't make loans because it's effectively insolvent does you little good. Ask the Japanese...

--Noam Scheiber