Paul Krugman and Sebastian Mallaby, among others, both argue that the federal government’s bailout of the financial system should take the form of equity investments banks, not the purchase of troubled mortgage assets. Krugman:
[T]he financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.
I almost agree. But the industry’s key problem isn’t lack of capital. Banks have already raised a ton of it—hundreds of billions, at last look. And if the government wants more new capital to flow into the industry now, there are plenty of things it can do (like, say, easing restrictions on private equity investments) to make that happen, short of investing directly.
Rather, the real problem that need’s fixing is the industry’s lack of liquidity--and the capital injections Krugman, Mallaby, and the rest have in mind won’t do much to fix that. Markets will only unfreeze once banks to start to have confidence in each others’ balance sheets again.
That’s won’t happen as long as (thank you, fair-value accounting!) the risk persists that institutions might take further negative marks to their impaired mortgage-related assets. The only alternative, then: those sick mortgages everyone seems to have exposure to have got to go. And the only buyer willing and able to take them in size is the federal government.
