Should the US Government Buy Bank Equity?

by: Felix Salmon

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.