I think that default is the best option.
But serious discussion of how you go about mitigating contagion in such an event seems to be lacking. I'd suggest that is a good idea no matter how badly some folks want to see a morality play.
Probably we can learn something from what we maybe should have done instead of TARP.
That would be a form of managed bankruptcy or restructuring for the banks in the basic order of bankruptcy claims- shareholder equity is wiped out first,the preferred shareholders, then general bondholders and finally if it takes that much- preferred bondholders.
Then comes the hard part. You'll have to figure out how to raise new capital for the banking system in a private market that is already reeling from some major hits from absorbing those huge losses.
If providing funding or guarantees from the public sector is strictly verboten then you will have to lean on the private capital market very hard and sustain some pretty steep losses in equity value across the board globally and very tight credit markets amid a sharply contracting economy.
And of course even without any public funding, tax revenues are going to drop sharply. And if you need to balance the budget by spending cuts, then employment and aggregate demand drop further.
Like I wrote earlier, the Republicans are geniuses- we need a depression now, before it gets worse. Although they weren't geniuses when they were voting for TARP and hoping to dump it on the other guys before it went bad.
