How much is the Obama administration planning to spend in its still amorphous financial bailout plan? According to the Wall Street Journal, government officials are talking about spending another $1trillion to $2 trillion dollars to help out banks.
Here are the options being discussed:
- Buy common shares. So far the government has been injecting capital by purchasing preferred shares that are far closer to debt than equity. The hope is that by having the government buy common shares, the government would increase the tangible common equity at the banks. That move might restore investor confidence in the long run. The first problem with this options is how to buy enough common equity to restore the financial health of banks without actually nationalizing the banks. The second problem is that current shareholders would be massively dilluted, which could make investors even more wary of putting money into banks and make private capital even harder to raise.
- Buy convertible bonds. We’ll just quote from the Journal: “Another way being considered for the government to inject money into banks is the purchase of convertible bonds — in which the government would be paid interest now but have the option to get common equity later. That would give banks a chance to pay back the bonds as they recover, and avoid government control. Some critics of this approach say it would do little to solve the banks’ current shortage of common equity.”
- Bad bank. The most powerful financial regulator in the world, Sheila Bair, is pushing hard for a government owned bad bank to purchase troubled assets from the banks. The main problem with this idea is one of pricing. If the price is too high, the government risks giving banks a windfall and rewarding irresponsible risky investments. If it is too low, banks either won’t participate or fall into insolvency.
- Insurance. The government could also insure distressed assets, limiting the losses at banks. This also creates a pricing problem. Since no one knows what the assets are worth, its impossible to price the insurance. The government could, of course, just insure the assets without charging anything, which creates a huge windfall for banks. Sadly, whenever this idea is discussed it is coupled with nonsensical happy talk about how we may never have to pay out on the insurance because the assets may actually be worth more than we think. In the Journal today, Columbia finance professor Charles Calomiris says exactly that: “You have to eliminate prospective stockholders’ concern that there’s a bottomless hole at the banks. Getting them off the books solves that problem, but insuring against the downside would have a huge positive effect and might end up costing nothing.”