Solutions to the CDS overhang

Solution 1: My first thought was this: Since too many of the dealer-counterparties can't honor their commitments and a chain of failures is the necessary consequence, there's nothing to do but nationalize all the dealer banks and, by aggregating them, wipe out their commitments to one another. However, since JP Morgan seems to have been relatively conservatively run, this is somewhat unfortunate. I imagined a conversation between Geithner and Dimon as follows: "Look, you prepared for a crisis, just not this crisis. I'm sorry we've got to nationalize JPM, but we do have a consolation prize: How would like to manage the great stinking bankpile as your government portfolio?"
(Look, Ma, bank's a four-letter word. Hoocoodanode?)

Solution 2: But then I went for my weekend jog and came up with what I think is a much better solution. Before buying or guaranteeing toxic assets, the government should require participation fees from the banks on the following basis: For each participating bank the Fed should sum the absolute value of the bank's net notional positions over each category of CDS. Let's call this number the bank's non-dealer position. The participation fee should be the non-dealer position (possibly after subtracting off the lowest non-dealer position, so that one dealer bank is guaranteed to pay nothing). The government may choose to finance this fee as a preferred stock-type loan.

What is the advantage of the non-dealer position fee? Two types of banks are creating chaos in the markets: those that guaranteed debt they could not afford to guarantee and those that ignored the dangerous exposure of their counterparties and bought insurance that they knew (or should have known) could only be honored if the government intervened in the market. Both sides of these trades were toxic. On the other hand, any bank that actually behaved as a dealer and thus carefully maintained offsetting positions in each market will find that its non-dealer position is small. This latter type of bank was relying only on the market continuing to function, not on being able to extract money from a government bailout. After paying the fee, every bank is entitled to government protection on it's CDS portfolio either via sales or insurance.

Thus the non-dealer position fee can force the banks that were engaging in the toxic aspects of the CDS trade to bear the costs of the bailout. Will these banks refuse to participate in the toxic asset purchase/guarantee plan? Possibly, but if so they can be required to mark their books to market and will most likely be nationalized due to insolvency. (If too many banks refuse to play ball, the government can "buy" the CDS from the true dealer banks and then play hardball with the CDS counterparties.)