Should the US Government Buy Bank Equity?

David Wessel has been hanging out with Myron Scholes, who wants the U.S. government to start buying equity in U.S. banks. Yikes!

Should the government (the U.S. government, that is, not foreign governments' sovereign wealth funds) put capital into banks?
"I think they should be considering it, at least thinking about it," Mr. Scholes said. "It seems to me that recapitalizing these entities would give us an opportunity to preserve the assets -- as opposed to dissipating their value through liquidation or foreclosure -- and provide a way for more capital to be infused into them without destroying value." ...
Mr. Scholes's solution: Let government invest both in debt senior to existing debt and in preferred stock senior to existing shares. Neither is advantaged versus the other. The bank doesn't dump assets and expands lending. If all goes well, the government gets out with a profit. One big caveat: This works only if assets truly are worth more tomorrow than they'll fetch today.

I think Scholes is a little bit behind the curve here: the government is already investing in "debt senior to existing debt". It's called the TSLF, it's the Fed's newest and shiniest toy.

As for the senior equity, I guess that what Scholes has in mind is something a little bit similar. The Fed would put up $100 billion, say, which would be available at equity-like rates, maybe 8% or 9%, to any bank wanting to issue a perpetual bond. (Perpetual bonds can be considered senior equity.) The bonds would be puttable back to the Fed at any time.

Doing it that way might deal with Hyun Song Shin's objection that injections of government capital risk bailing out existing equity holders: if the government ends up losing any of its money, then existing equity holders would be wiped out.

I'm personally not convinced that extending unsecured credit to banks is a particularly smart way to go, especially not when there still seems to be appetite in the capital markets for bank capital securities. (See SocGen.) Still, if things continue to deteriorate, there is a chance that desperate times will require desperate measures.

Comments

[BxCap:]

Hey Scholes. Thanks for "options". It's really helped stabilize the world's largest casino.

2008 Mar 13 11:03 AM

[Dana Cole:]

Is it possible that the banks themselves are causing all these problems by their refusal to extend credit on the very loans they made and then sold to others?

2008 Mar 13 11:15 AM

[Tony Soprano:]

Two stories or analogies that reflect the realities of today.

First story:

"Here is an analogy ...your teenager has maxed out their credit cards and is to a point they can no longer make payments. You step in as a co-signer and get the limits on the cards doubled."

Is this the right decision? This is what the Fed did for the banks yesterday. from Mr Nofate
______________________...

Second story:

"The son does use a credit card but instead of spending it on himself he wants to lend out the money and become loan shark. His idea is to lend out as much money that he can. In the mean time people that he is lending out to all live on an island. The island depends on a dike system to keep the island from going underwater. The dikes take an enormous amount of power to run. The islanders are taxed a lot to keep the power going..

The loan business is slow starting and the son wants it to grow much faster. His rich daddy is still backing him up and thinks his son is remarkable. The son's new business plan offers loan owners interest in a new waterfront country club if they barrow more. They see it as a steal and it makes them feel rich so they barrow more. His new business plan is a success for many years. The new country club is well under construction. Most of the people on the island are happy and think they have it made. The son pockets a good deal of wealth but he always wants more and more.

As more time passes, the cost of the power to run the dikes starts to increase rapidly. Sadly some of the islanders become sick. The doctors on the island suspect the Avian virus. Some even die and others cannot work. Unemployment starts to rise dramatically and the power for the dikes continues to rise.

Not all of the islanders owe money to the son. Many are still wealthy and never liked what the son has done and they are very much concerned about the rising cost to power for the dikes. More time passes and construction cost for the country club increases as well. Construction on the project starts to slow down. Many on the island start to become angry.

Taxes receipts to pay for the power for the dikes starts to diminish. Some of the islanders want to raise taxes to pay for the power. The islanders that are sick are not paying taxes. A meeting is called. The meeting is a failure and the son goes into hiding. However, the islanders come up with another plan but still many on the island do not like the newer plan as well

The newer plan requires the islanders to barrow more money but from the mainland. The wealthy on the island do not like this plan because it will require them to pay more taxes in the future. However, some of the middle class people on the island become restless and crime increases.

The islanders are at a serious crossroad. Damned if they do and damned if they don’t. Many on the island say the island will sink completely underwater if new monies are not borrowed. Others do not agree and feel the island will be on okay without the additional debt."

I’m not going to finish this story. I will let your imagination do the rest.

But my point is we can let GM or Ford go under and we will still have cars. However, we cannot take this chance with the banks. Banks are the corner stone, hence the island metaphor, of our capitalism. If the banks sink we all sink. We cannot afford to take the slightest chance that this will spread further and sink us all. At the same time it’s a shame that a lot of our mortgage companies, brokerages firms and money center banks let this happen.

2008 Mar 13 11:19 AM

[hybridair:]

We may need to come to the aid of the banks, but we should also tighten the reins on their behavior to lessen the chances of them getting into the problems they have. Stricter regulation of practices and the business areas in which they are allowed to participate.

2008 Mar 13 06:57 PM

[robert99:]

Soprano, take your ridiculous story elsewhere. Do you think the banks did not know this was going to happen? Bubbles are elementary economics - People were shouting their heads off about this five years ago. The banks knew. The FED knew. Take a look at the Shiller Used Home Price Index, adjusted for inflation, since 1890. It was clear even five years ago that the bubble was huge, and yet, Greenspan dropped interest rates to 1%, held them there, encouraged ARM loans, and of course, the banks were eager to listen. Why? Because they KNEW THEY WERE GOING TO BE BAILED OUT WHEN EVERYTHING CAME CRASHING DOWN - And the CEO's, hedge funds, etc all made big bank off the housing boom. When things go sour, do they give that money back? Yeah, right. The answer obviously does not lie in allowing massive bank failure, because the banks planned their actions based on the assumption they would be bailed out; the shift to free markets must be a gradual thing. But the banks need to feel some pain - SOME REAL PAIN. Unfortunately, very few people actually understand truly free markets as the world has NEVER SEEN THEM on a large scale. Maybe we will continue to head in that direction, but after the full extent of housing's crash makes itself known in the economy, my guess is that the people, like a bunch of moron lemmings, will all cry for more regulations....

2008 Mar 13 08:02 PM

[Bela Ghoulashi:]

Could we tighten a few reins on Tony while we're at it?

2008 Mar 13 08:14 PM