The Weakness of the Treasury's New Bailout Plan

The scorpion, it seems, is staying as true as he can to his nature. And although I'm the first to admit that this is no time to worry overmuch about moral hazard concerns, the slowly-emerging shape of Treasury's plan to recapitalize the banking system worries me.

The idea seems to be, in the first instance, that Treasury will buy nonvoting preferred stock in America's nine largest banks. They surely include the ones whose CEOs met with Hank Paulson in Washington today: Bank of America, JP Morgan Chase, Goldman Sachs, Morgan Stanley, Citigroup, and Bank of New York Mellon. Wells Fargo will be on the list too, and a couple of others.

In the case of the most solvent banks, this is a necessary annoyance. They might not like raising equity at these levels, but they need a working banking system as much as anybody else, and if that involves destigmatizing Treasury capital, then so be it. Note that in the UK, the two biggest recipients of government capital, RBS and HBOS, both saw substantial falls in their share price today, while Barclays, which said thanks-but-no-thanks to the government, rallied impressively.

It's not entirely clear what Treasury's capital injections are for, however. On the face of it, since they're aimed at all banks, not just those in trouble, they're not an attempt to restore solvency. But that might change when we see the numbers: if Morgan Stanley ends up getting much more cash than Wells Fargo, the impression will change.

There's a symbolic element to the recapitalization: with the government buying preferred shares, it's essentially saying that it has no interest in supporting the stock price, but that there's no way it will allow sub debt or any other bondholders to suffer. And that symbolism is backed up by explicit intent:

The FDIC is expected to temporarily extend its backstop from bank deposits to new funds raised by banks and thrifts for three years. That would be an aid to companies that have had a hard time raising capital without government assistance.

This bit of the plan, incidentally, I like. With Frannie buying up toxic assets and the FDIC insuring bonds, that frees up most of the TARP funds to be used for recapitalizations.

But the broad-brush approach of the proposed plan, with no voting rights and seemingly very little due diligence, worries me. Pricing the Treasury's preferred stock will be a bugger; I have a feeling they might just make all the banks pay them a nice round 10% and leave it at that, with the banks having a call option after say three years.

But that one-size-fits-all approach, especially when it's combined with the present bank management which got us all into this mess to begin with, is a recipe for hail-mary passes and other forms of counterproductive risk taking.

If you're running an insolvent bank, and you get a slug of equity from Treasury, your shareholders will thank you if you use that equity to take some very large risks. If they pay off and you make lots of money, then their shares are really worth something; if they fail and you lose even more money, well, there was never really any money for them to begin with anyway.

Brad Setser has it right, I think:

A world where the government guarantees the ability of privately owned banks with potentially troubled balance sheets to raise wholesale funding is neither desirable nor necessarily stable for long.

I asked Brad to clarify, and he wrote back:

If the guarantee is credible then an institution with little or no equity has the capacity to raise wholesale funds to gamble for redemption.
And those bets are a potential source of instability.
Regulation theoretically can limit this risk, and right now there is enough fear that I am not sure that it is most immediate risk -- but conceptually, the incentive to make big bets with the government's guaranteed money is there.

This is a real risk, I think, especially when you're talking about banks like Morgan Stanley whose books are very opaque and which can lever up substantially within minutes should they feel like it.

There's no sure way to prevent such risk-taking altogether. But if you go the UK route and insist on board seats and the ouster of failed executives, it helps. That's what Treasury did with AIG, and they should do the same with the banks they're rescuing. If they don't, they're basically getting all of the downside of nationalization with none of the upside.

I'm quite sure that Paulson hates the fact that he's semi-nationalizing the banking system. But he needs to get real and accept it, rather than trying to brush it under the carpet. Otherwise he's putting hundreds of billions of taxpayer dollars at unnecessary risk.

Update: The Big Four banks get $25 billion each. That's $100 billion gone right there; I hope it's worth it.