Held Hostage: What Happens If They Still Fail?

We suppose there are good reasons for the government to own preferred shares in banks participating in the enormous recapitalization plan, not the least of which is allowing the government to expect some upside potential in exchange for all the risk it is taking on. But are we paying enough attention to that risk?

Government ownership of financial equity will create a dynamic that all but guarantees we will have to inject more money into institutions that continue to fail. If the Stockholm syndrome involves captives sympthazing with their captors, we’re about to experience the Wall Street syndrome: where the Treasury Department finds itself at the mercy of financial institutions whose equity it all but seized. After all, allowing a firm we have funded to go under will wipeout our investment. To politicians and regulators, it will only make sense to double down.

The logic of sunk costs rarely holds sway in Washington, DC. So it’s a good bet that any firm we own a piece of now will have all but unlimited access to additional government lines of capital and credit. Unlike a standard equity investment, in which downside risk is limited to zero, we’re likely to keep pouring money into these firms. We have, in short, unlimited downside risk.  What an amazing new financial product the central bankers have invented.

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