What Paulson Has Against Preferred

A primary objection many people seem to have to the Paulson plan is the unwillingness of Paulson and Bernanke to take preferred shares in any financial service company that participates. The argument is that if we are going to bail you out by overpaying for illiquid paper at prices higher than market, then there better be a stake for taxpayers in the offending company. After all, as Jeff Matthews points out, why can't we get a better deal for bailing out awful firms than Warren Buffett can get by investing in a good firm?

The Paulson/Bernanke response, it seems, is that they oppose anything that would keep firms from participating in the program. To that way of thinking, taking preferred shares in the firms would make them think twice about participating, which would be bad insofar as the real goal here is to speedily vomit up as much of this toxic paper as we can. Slowing that process down defeats the purpose and makes the bailout turn Japanese.

My thought. I take the point, and in some sense I agree, but it is impractical and unpalatable. The plan currently reeks of bailout, with no dilutive quid pro quo. The sooner we get past this point the better, and it looks like it is Paulson and Bernanke that are going to have to give in.

However:

Dr. Strangelove: Of course, the whole point of a Doomsday Machine is lost, if you *keep* it a *secret*! Why didn't you tell the world, EH?
Ambassador de Sadesky: It was to be announced at the Party Congress on Monday. As you know, the Premier loves surprises.-- Dr. Strangelove (1964)

Paul Krugman articulates something I've been saying for a few days now, and that I tried to say here above. My guess is that Paulson believes that we have a locked market in mortgage-related securities, and, rather than bailing out every company in sight, he hopes that he and Bernanke can slap the market's face and get it moving again. Were that to happen, so the theory goes, much of the paper currently trading at absurdly low prices would spike higher, neatly allowing the market to solve its own insolvency/illiquidity problem -- without necessarily using all the capital in the TARP plan.

If true, that would also help explain the Paulson-ian aversion to preferred shares. Why complicate things if you actually think that a small injection of capital can restart the market?

It's a dangerous and interesting theory. If it works, he'll be a hero, having bailed out the financial sector speedily and inexpensively. If it doesn't work, however, it will mean we have poured billions of dollars into useless face-slapping with nothing to show for it, other than a badly-bruised and increasingly comatose patient.

In answer, however, to Krugman's point about being more transparent about the idea if that's really the plan, the answer is you can't. Because the face-slap only has a chance if you're not expecting it to work that way. In a Strangelove-ian sense, it's an anti-doomsday device, in that the latter only worked if you told people. This stops working if everyone knows.

Comments

[LindaG:]

IT IS VERY INTRIGUING ON THE INTENSE PUSH FROM PAULSON TO HURRY THIS MASSIVE BAIL OUT! IT BRINGS MANY QUESTIONS TO MIND! WHY SHOULD YOU HURRY AND RUSH SOMETHING OF THIS MAGNITTUDE WITH NO POSITIVE GUARANTEES. I DO THINK AMERICAN PEOPLE NEED TO WAKE UP AND QUIT BEING SO PASSIVE, LETTING THE GOVERNMENT WALK ALL OVER US AND GIVE US NO INVOLVEMENT IN THE DECISION!.........LIND... S.E. TEAXAS AFTER IKE

2008 Sep 24 01:37 PM

[Obama is Bu...:]

There is a very easy way to make sure the banks participate in the program:

The Fed needs to stop providing financing for these toxic assets at imaginary collateral prices and at way below market rates. The Fed should provide financing valuing the collateral at mark to market prices and charging market rates of interest -- which is what it should have been doing all along.

The Fed's foolish "emergency" financing schemes are what prevents banks from participating (can we still call these "emergency" after more than a year?)

2008 Sep 24 01:46 PM

[User 268076:]

The american peeps are not being passive. It's just that nobody is listening!! Soon we will be talking much more loudly thanks to the 2nd amendment.

2008 Sep 24 04:38 PM

[Scrooge90210:]

The Treasury can loan out money to financial institutions that steered away from toxic assets like the ones causing the need for a bail out. In exchange for nominal interest and tax-exemption from profits associated with purchases from ailing institutions, competent financial institutions can reap profits and help out the US govt.

The govt can also bail out companies in exchange for an equity stake, but the govt can offer a rebate if returns on such holdings exceed the initial buyout plus nominal interest.

The government can do what Buffett did for Goldman Sachs, but without the need for high returns. A loan payback would suffice.

Some mix of different ideas would have to be on the table, because I don't think there is a magic bullet here.

2008 Sep 24 08:51 PM

[bbowen7:]

We the people will have our pound of flesh.
- Limits on Wall Street CEO compensation, or at least no rewards for failure;
- A piece of the action;
- Strict regulation of the whole gang - investment banks, hedge funds, the money changers in the temple.

2008 Sep 25 12:51 PM