Some thoughts from a rather controversial individual on adjustments to the Paulson Plan that seem, for better or worse, somewhat similar to ours:

a rescue package was desperately needed and, in spite of its shortcomings, it would change the course of events. As late as last Monday, September 22, Treasury secretary Hank Paulson hoped to avoid using taxpayers’ money; that is why he allowed Lehman Brothers to fail. Tarp establishes the principle that public funds are needed and if the present programme does not work, other programmes will be instituted. We will have crossed the Rubicon.

Since Tarp was ill-conceived, it is liable to arouse a negative response from America’s creditors. They would see it as an attempt to inflate away the debt. The dollar is liable to come under renewed pressure and the government will have to pay more for its debt, especially at the long end. These adverse consequences could be mitigated by using taxpayers’ funds more effectively.

Instead of just purchasing troubled assets the bulk of the funds ought to be used to recapitalise the banking system. Funds injected at the equity level are more high-powered than funds used at the balance sheet level by a minimal factor of twelve – effectively giving the government $8,400bn to re-ignite the flow of credit. In practice, the effect would be even greater because the injection of government funds would also attract private capital. The result would be more economic recovery and the chance for taxpayers to profit from the recovery.

This is how it would work. The Treasury secretary would rely on bank examiners rather than delegate implementation of Tarp to Wall Street firms. The bank examiners would establish how much additional equity capital each bank needs in order to be properly capitalised according to existing capital requirements. If managements could not raise equity from the private sector they could turn to Tarp.

Tarp would invest in preference shares with warrants attached. The preference shares would carry a low coupon (say 5 per cent) so that banks would find it profitable to continue lending, but shareholders would pay a heavy price because they would be diluted by the warrants; they would be given the right, however, to subscribe on Tarp’s terms. The rights would be tradeable and the secretary of the Treasury would be instructed to set the terms so that the rights would have a positive value.

Private investors, including me, are likely to jump at the opportunity. The recapitalised banks would be allowed to increase their leverage, so they would resume lending. Limits on bank leverage could be imposed later, after the economy has recovered. If the funds were used in this way, the recapitalisation of the banking system could be achieved with less than $500bn of public funds.

You may disagree with the source of this proposal on his politics, but he has been calling attention to some of the serious structural problems in our financial system for some time now. (Even if some equity element is included in a final package, it would be a mistake to give any corporate governance rights to the government officials who helped create our current problems.)

UPDATE — Speaking of the need to raise equity capital, General Electric, of which half is essentially a bank, underscored the importance of doing so in its planned sale of $15 billion in equity at discount prices. $3 billion in preferred stock will go to Warren Buffett with a 10% dividend and below market warrants, and $12 billion will take the form of a common stock offering. GE’s shares have fallen by 42% this year, according to the NYT. GE’s willingness to sell equity at bargain basement prices to preserve its AAA rating is an indicator of the importance of adding incremental equity capital to financial institutions in the current environment.

This entry was posted on Thursday, October 2nd, 2008 at 1:32 am and is filed under Democrats, Republicans, business. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.