Guaranteeing Bank Stock Prices Is Not the Answer

By James Kwak

Less than a week after pulling off the media coup of publishing his universal credit insurance proposal in both the FT and the WSJ on the same day, Ricardo Caballero has a new proposal for solving the banking crisis, this one in tomorrow’s Washington Post.

He should go back to the last one.

Here’s the new proposal: “The government pledges to buy up to twice the number of bank shares currently available, at twice some recent average price, in five years.” According to Caballero, this will have the following effects:

1. Because bank stocks immediately become more valuable, it has a wealth effect that pushes up the value of all assets.
2. Banks will be able to raise private capital, because they can issue additional shares equal to all of their outstanding shares, and these shares will have a price floor.
3. Because this will have a stimulative effect and will solve the bank capital problem, the economy and the banking sector will go back to normal, and five years from now the government won’t actually have to buy any shares, because they will be trading above the government-guaranteed price floor.

Let’s start with the most important issue: fixing the banking sector. Caballero’s credit insurance plan would solve this goal, because it involves cheap government insurance for all bank assets. This new proposal, by contrast, is a private sector recapitalization plan. Essentially, each bank would be able to raise new capital (by selling shares) equal in value to twice its current market capitalization, because those shares are guaranteed. For Citigroup (C), that would be about $20 billion. Does anyone think that would be enough to lift the clouds hanging over Citi? JPMorgan (JPM), by contrast, could raise about $150 billion. But there’s nothing saying that they have to, and bank managers who think that twice their current share price is still undervalued will have no new incentive to raise capital.

This is especially true because of the perverse incentives this plan creates, which make it especially hard to understand. This plan creates a government guarantee on the stock price. In other words, it says, “No matter how stupid you are, what ridiculous risks you take, and how bad your bank is, we will buy your stock at an artificially inflated level.” Is this really the way to create a healthy banking system? I understand why people are afraid of government control over banks, but this seems at least as bad to me, since it creates an obvious incentive to take excessive risks. In addition, this takes away the usual incentive for raising capital: the need to maintain capital adequacy levels. Now that the government has guaranteed that shareholders will not lose their capital, no matter what, why raise more and split the upside with new investors?

What about the stimulative effect on the economy? Basically bank stocks would double in value overnight. Now, the S&P 500 Financial Sector Index is down about 80% from the summer of 2007; banking stocks are probably down a little more, say 85%, and insurance stocks down a little less. So the day after this plan is announced, your bank stocks - by now a small part of most portfolios - are down only 70% instead of 85%. While this might have some wealth effect, I think it would be relatively small; among other reasons, stock holdings and retirement accounts have a relatively small impact on consumption, compared to wages, dividend and interest income, or even home values (because they can be used for home equity lines). And I don’t see how it could turn around the economy.

Besides, if the idea is to stimulate the economy by making people feel wealthier, the simplest and fairest way to do this is through a tax cut. But the problem with tax cuts right now is that most of the tax cuts will simply be saved. This should be even more true of the Caballero plan, which just makes your banking stocks double in value. And if we are looking for creative ways to make people feel wealthier, what about a government guarantee to buy your house, in five years, for whatever you paid for it? (That was a rhetorical question.)

But, Caballero says, the great thing about his plan is that it is free. Because the plan will turn around the economy and return the banks to normal, the government will never actually have to buy the shares. This is wishful thinking in its most pure form. Yes, it is possible that if we fix the banking system, the economy will turn around, and most of these troubled assets will return to something like their current book values. But in that case, every proposal anyone has offered will turn out to be free.

Caballero’s credit insurance plan will cost nothing, because the government will never have to cover any losses. Paulson’s plan to buy toxic assets will cost nothing, because those assets can then be sold for more than the government paid. The nationalize-reprivatize plan will cost nothing, again because the the government can sell the bad assets at a profit. Buiter’s and Romer’s “good bank” plan will cost nothing, because the good banks will be worth more than the capital it takes to set them up. A government recapitalization plan - say, for example, the government buys, at twice the current price, a number of shares equal to the current shares outstanding, will cost nothing, because the government’s new shares will be worth more than it paid for them. (This is similar to Caballero’s plan, except we know that the banks will actually raise capital, and the taxpayer gets the upside as well as the downside.)

But as Martin Wolf put it in a post I’ve recommended before and recommend again, “the heart of the matter . . . is whether, in the presence of such uncertainty, it can be right to base policy on hoping for the best.” That question answers itself.

Comments

[HiSpeed:]

Wow, another stupid idea is which the taxpayers get stuck with bill. The shorts will pile on with both fists if such a poorly though-out situation presents itself.

The economy is coming off a 25 year credit bubble! The government may be able implement some programs to alleviate some of the pain but the bubble will pop - they ALL do!

Just nationalize the banks already -we already know nationalization - or some derivative of it - is coming.

Feb 21 04:49 PM

[TKO:]

This plan is more or less a bundle of put options being sold by the banks with a strike much higher than the current price, but the banks get no premium upfront. The direct value is completely negative for tax payers because there is no way they can directly win with this deal.

However, the indirect effect could be:
1) An increase in shareholder wealth for these banks. The net effect would, at the very least, be a 0 sum game with few people (shareholders) being made better off with many people (tax payers) being made worse off.
2) An increase in investor confidence. The $7 trillion or so in cash sitting out of the equity markets may be reinvested back in, either in the forms of equity or other investments, as there would be a decreased level of uncertainty.
3) As private capital starts to move back in, leading indicators may start to pick up steam towards the positive renewing hope for economic recovery. Manufacturers forecasting a prolonged recession may revise their forecasts and put on hold potential layoffs in light of this.
4) And so on.

The doom and gloom surrounding this world today began with the subprime debacle. Banks started to tighten up, preventing much needed loans for continued economic growth. Manufacturers saw less opportunity for growth, lowered their expectations, and it snowballed into large scale layoffs.

Folks, you can blame this on overextension of credit, but what stopped the economic growth wasn't the overextension of credit -- it was quite the opposite -- it was the lack of credit. It is when the expectations began to turn sour, and because of leverage, it simply magnified the snowball that occurred.

What drives this world is nothing more than consumer and investor psychology. What this world needs is confidence.

Feb 21 05:18 PM

[Carneades:]

Potential Government Missteps
As we progress through the various stages of financial deterioration, the Government is left with an increasingly weaker hand. An appropriate analogy may be that of a chess game, with the Government on one side of the table, and the Market on the other. As any chess player knows, the key to victory is the ability to see several moves ahead, and to assess your opponent's most likely reactions. We liken the Government's varied reactions to our current predicament to the actions of a novice chess player. A beginner tends to deploy his crucial pieces for attack, despite having only planned the assault one or two moves in advance. In addition, a novice chess player will generally fail to recognize a threat until it is too late. This current match against the Market has not gone favorably for the Government. Each attack has led to a more sophisticated counter-attack. Repeatedly, the Government has claimed victory over the capture of a pawn, only to realize that it has lost a rook in the process. We now stand in the latter stages of the game, and the Government's pieces are few.

It has become painstakingly clear that the end game will involve some form of nationalization of a number of major financial institutions. We feel that nationalization is, and has been, a necessary evil given the current predicament. However, we remain skeptical as to whether the Government is capable of crafting a strategy that will save the banks without triggering profound global repercussions. We focus specifically on Citigroup, as it is both the weakest and the most systemically significant institution. Citigroup operates in over 100 countries worldwide, and does so under numerous ownership structures. For example, Citi "controls" the second largest bank in Mexico by assets.

Obviously, the global reach of Citi obfuscates any Government nationalization scenario. We are concerned primarily due to the Government's inability to think or act with any degree of nuance. If the Government did not anticipate the consequences of the decision to allow Lehman Brothers to fail, we are gravely concerned about its ability to effectively nationalize an insitution such as Citi, whose tentacles reach to every corner of the globe.

Feb 21 05:33 PM

[klarsolo:]

Your argument that this plan creates perverse incentives might sound valid on paper, but in practice it doesn't work. Do you really believe any of the big banks would start reckless lending left and right because of a plan that can be revoked at anytime whenever the government pleases? Do you really believe they would stake the future of their bank on this?

What we need is more confidence in the markets, plain and simple. Looks like every blogger is crapping over every single idea that doesn't involve nationalization. Why are people begging so much for more capital destruction? This won't fix anything. Lehman's bankruptcy last year must have made all these people's wildest dreams come true. Everybody got wiped out, all them greedy bankers. But why did create such incredible chaos then, if it is such a good idea?

Do you guys not get it that when you start destroying capital in Bank A, you also destroy capital in Banks B,C,D, and E? The markets at this juncture can't think rationally; they'll instantly replicate whatever you do to one bank to every other bank and insurance company; regardless of them being healthy or not. Is this what you want? Gradually nationalize every single financial institution? Are you guys all short?

Any plan that will work does not involve more value destruction, but a buildup of confidence. Now bloggers, up and at'em. Come up with some good, original ideas. Don't just tear down what other people come up with; you can do that with ANYTHING, but that ultimately proves nothing.

Feb 21 06:53 PM

[citetez:]

The real underlying problem is the mark to market rule which has unnecessarily made banks look insolvent on papaer creating a self-fulfilling negative feed back loop. The process has gone something like the following: 1) Alt A and other subprime products start having higher default rates. 2) "Experts" suggest that the problem may creep into other mortgage classes 3) Subprime loans are termed "toxic" 4) Soon alomost all mortgage products are calld "toxic" (no one knows what that means or cares except that it makes the products kryptonite) 5) PERFORMING AND NON-PERFORMING ASSETS ARE TREATED THE SAME, ie AS IF WORTHLESS. 6) The market for these assets tanks -- no one wants to pay the cash flow value for an asset they now have to carry on their balance sheets as if it were worthless 70 bank capital ratios tank -- they have to treat mortgage paper as if it were worth 22cents to 40 cents on the dollar EVEN IF THERE HAS NOT BEEN ONE EVENT OF DEFAULT 7) Banks, understandably do not want to sell an asset whic is performing perfectly and generating the anticipated cash flow for the price they would get if it were in fact in default 8) People like Rubeni get on CNBC and announce that banks are "insolvent" because they have to value their mortgage holdings as junk whether they are junk or not 9) Due to an artificial valuation rule the banks have to raise capital to meet ratios even if their actual dollar losses are minimal 10) It looks like the the banks are in fact insolvent (even if the actual cash flows are still good) 11)The stock prices tank reinforcing the scenario 12) The vulture investors scream for nationalization knowing they wll make a killing if the banks are forced to cave in and sell good assts at bad prices. THE ANSWER: Let banks carry on their bools the mortgage assets based on performance and ACTUAL CASH FLOWS, not on the fictious "market price" when the market has temporarily disappeared and no one really wants to sell now ayway.

Feb 21 08:42 PM

[Duke Wong:]

I'm supporting Obama's stress-test, We can not keep spending taxpayer money. If an bank that doesn't fit to the currently environment then let it fail, we only support the working bank and bring up our economic.
We need time to fix. The time is depending on the problem, the bad problem would need more time.
The stock market could drops further but it will recover when the fundamental is good, the problem is fixed.

Feb 22 07:29 AM

[John Lounsbury:]

James - - -

You wrote: "But, Caballero says, the great thing about his plan is that it is free. Because the plan will turn around the economy and return the banks to normal, the government will never actually have to buy the shares."

Caballero is engaging in some other same dangerous thinking as all too many CDS participants over the past several years: There is no risk because it is unthinkable that failure can occur to the extent that we will have to pay off on the credit we are guaranteeing.

I have long since learned in anything speculative, the likelihood of loss is greatest from the event I have not hedged against. I don't care if it is unthinkable, it's probability of occurence goes way up if I ignore it.

Am I paranoid? Yes, but still solvent, unlike some supposedly much smarter people (or institutions).

Feb 22 01:35 PM

[User 359637:]

You have to blame it on overextension of credit. By it's very definition credit has to stop increasing at some point and start being repaid. Hitting your credit limit and being denied credit is a logical outcome of overextending your credit. This applies even at a national level.


On Feb 21 05:18 PM TKO wrote:

> This plan is more or less a bundle of put options being sold by the
> banks with a strike much higher than the current price, but the banks
> get no premium upfront. The direct value is completely negative for
> tax payers because there is no way they can directly win with this
> deal.
>
> However, the indirect effect could be:
> 1) An increase in shareholder wealth for these banks. The net effect
> would, at the very least, be a 0 sum game with few people (shareholders)
> being made better off with many people (tax payers) being made worse
> off.
> 2) An increase in investor confidence. The $7 trillion or so in cash
> sitting out of the equity markets may be reinvested back in, either
> in the forms of equity or other investments, as there would be a
> decreased level of uncertainty.
> 3) As private capital starts to move back in, leading indicators
> may start to pick up steam towards the positive renewing hope for
> economic recovery. Manufacturers forecasting a prolonged recession
> may revise their forecasts and put on hold potential layoffs in light
> of this.
> 4) And so on.
>
> The doom and gloom surrounding this world today began with the subprime
> debacle. Banks started to tighten up, preventing much needed loans
> for continued economic growth. Manufacturers saw less opportunity
> for growth, lowered their expectations, and it snowballed into large
> scale layoffs.
>
> Folks, you can blame this on overextension of credit, but what stopped
> the economic growth wasn't the overextension of credit -- it was
> quite the opposite -- it was the lack of credit. It is when the expectations
> began to turn sour, and because of leverage, it simply magnified
> the snowball that occurred.
>
> What drives this world is nothing more than consumer and investor
> psychology. What this world needs is confidence.

Feb 22 03:15 PM

[morning reader:]

Hi-speed, i agree that the economy is coming off huge credit bubble that took years to accumulate, but i dont beleive that nationalization is the answer. let the market work out on its own.

Feb 22 03:15 PM

[morph366:]

Thanks for re-posting the link to Martin Wolf's excellent article in the FT - a clear a statement of the challenge that has to be met.
I am glad I didn't give up half way through your article regarding Mr Caballero's nonsense or I would have missed the link to Mr Wofl's piece.

Feb 22 03:17 PM

[prudentinve...:]

While they're at it, I'd propose they should also pledge to buy up to twice the number of (DOW, GE, IP,......) shares currently available, at twice some recent average price, in five years.

This too will have a wealth effect that pushes up the value of all assets, and will allow these companies to be able to raise private capital ......

(disclosure: Hold positions in the stocks mentioned)

Feb 22 08:30 PM