Recapitalization and the Implicit Treasury Guarantee

Tyler Cowen has a very good question:

Treasury equity is not the same as debt to the Fed, but are they so different? In some ways the Fed's I - can't - just - stop - rolling - it - over - when - I- want contribution is a bit like preferred equity.

I think main key difference is one of credit risk. If Big Bank has access to the Fed's liquidity facilities, that's all well and good, but doesn't protect Big Bank's creditors (just ask anybody who lent money to WaMu). On the other hand, if Big Bank is state-owned, there's an implicit government guarantee on its liabilities: the German word for it is Anstaltslast.

We've already learned with AIG that once Treasury takes a large equity stake in a company, it will extend as much credit as necessary to keep that company going. Now Treasury owns 80% of AIG; maybe it wouldn't make the same decision with Morgan Stanley (MS), say, if its equity stake was much smaller than that.

But if Morgan Stanley does get a Treasury equity injection, I'm pretty sure the stake will end up being a majority one. Treasury would need to inject much more money than MUFG's $9 billion before the market even started getting reassured about Morgan Stanley's viability -- and the bank's entire market capitalization right now is only $8 billion.

And once Treasury has a majority stake, I think bondholders are safe. Otherwise, what's the point of taking that majority stake in the first place?

Once bondholders are safe, of course, the institution in question will be able to start tapping the interbank markets again. And that could help the entire banking system.

But why do this on a case-by-case basis? A blanket government guarantee of all banking-sector liabilities should have the same effect. Just like the initially conceived TARP was overtaken by events and became an equity-injection device, the plan to take equity stakes could well be overtaken by this weekend's meetings and become a universal guarantee instead. (Of course, such a guarantee should absolutely be accompanied by equity stakes in banks, otherwise the government has all downside and no upside.)

Truly, things are moving fast. The really big question is whether they're moving fast enough.

Comments

[Obama is Bu...:]

Mr Salmon -- normally you have some really good market commentary, but maybe you haven't had enough sleep this week (no one has)

A blanket guarantee of all assets is a foolish idea. Hopefully, I don't need to explain to you that all assets are not equal.

If everything becomes (effectively) a Treasury bond, one of two outcomes must happen:
(1) As happened with Iceland, all assets lose value... this seems unlikely in the U.S., but lets remember that we have no domestic savings so it isn't completely impossible
(2) All assets are as credit worthy as Treasuries, but clearly some Treasury assets are much better than others -- and get a higher price. And the reverse, some "Treasury" assets are clearly not as good and their price should go to zero (or to what they might fetch in bankruptcy).

There is almost no difference between scenario two above and the current situation except: cash rich persons like Warren Buffet can snatch up assets that pay 10% and pay for them as though they were Treasuries paying only 4% -- so cash rich people get a windfall.. and two, future taxpayers (better known as OUR CHILDREN) get hit with the cost of making garbage assets pay off as though they were Treasuries.

Please Mr Salmon -- don't screw over our children with a bunch of voodoo accounting. All assets are not the same and we all know it.

2008 Oct 10 04:04 PM

[Rhunzzz:]

The way I see it, preferred stock has certain advantages over debt and common stock, from the point of view of stabilizing financial institutions.

1. Flexibility. A bank who misses an interest payment is in default, but it can miss a preferred dividend so long as it makes it up later (if the pref. is cumulative). Also, the bank does not necessarily have to pay back the principal for the preferred, it has the option of calling it.

2. No voting rights. The government does not want to be in a position where it must actually be running the banks, nor does it want to be seen as having such rights, nor does it want to dilute the common shareholders.

Am I right on this?

2008 Oct 10 04:39 PM

[whidbey:]

In the meanwhile the Treasury rolls the bond holding public and leaves then bloody and reeling to get the largess to speculate on their bailouts. This exhibit of crass exploitation will cost Treasury eventually as it finds it has no buyers at any price because it is clear it has no respect for the public debt holders.

2008 Oct 10 06:17 PM