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A Modest Proposal
It is clear to me that we have to do something and do something soon to resolve the mess on Wall Street. The financial system is facing both a liquidity problem and a solvency problem. I would set up what would be in effect a U.S. sovereign wealth fund. This fund would then buy -- at current market prices -- new stock in large financial institutions, giving the fund a 49% stake in each institution. The shareholders of these firms would be diluted, but the institutions would then be adequately capitalized.
In essence, the problem is that we have too much leverage (assets/equity) in the system. The Paulson/Dodd proposals essentially attack the problem from the asset side of the equation. This proposal would attack it from the equity side of the equation.
The Paulson/Dodd approach would buy up troubled assets. However, much would depend on what price would be paid for these assets, most of which are currently very illiquid, opaque, complex and far from homogeneous. If the price paid was close to recent market prices, then banks would still have to recognize a big loss and their capital would be depleted. It would only help the banks if the price paid was well above the current market prices.
The difference between market price and the government-paid price (what Bernanke was referring to as the "held to maturity" value) would in effect be a direct subsidy to the asset seller. That would help shore up a bank's capital position and also give it some cash to resume lending. As losses are recognized, however, it directly hurts the bank's capital (unless the asset has already been marked down to that level or lower). Both assets and equity go down, but on a percentage basis equity goes down further, which increases leverage. Also, it is not at all targeted to those institutions which are the most under-capitalized; the subsidy goes to whichever institution sells the asset.
The equity approach would also provide the banks with fresh cash to lend with. However, it comes with a stiff price, as the existing shareholders are diluted. However, if an institution is leveraged at 20:1 then you get 20x as much bang for your buck in bringing down leverage by attacking the 1 than you do by attacking the 20. Also, the price of the equity is open, liquid and transparent. There is no difficulty in judging how much to pay, and when the markets recover, the taxpayer gets lots of upside. For $700 billion, at current market capitalizations, taxpayers could own 49% of most of the Financial sector.
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| Market Summary | Sep 09, 2010 02:14 am ET |
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