Out of Control Policy Blog

Buying bank equity is another bad move

The Bailout has officially changed. According to an AP report, Secretary Paulson confirmed today that the $700 billion will go towards buying equity in banks and not any mortgage-backed securities:

Paulson said the government's $700 billion financial rescue package will not purchase troubled assets from banks as originally planned. He said that plan would have taken too much time, and that the Treasury instead will rely on buying stakes in banks and encouraging them to resume more normal lending.

While the market had been pleased by the government's decision weeks ago to buy banks' stock, investors still hoped to see the financial industry relieved of the burden of the mortgage assets whose decline in value helped set off the nation's financial crisis.

Paulson also announced a new goal for the program to support financial markets which supply consumer credit in such areas as credit card debt, auto loans and student loans. He said "with a stronger capital base, our banks will be more confident" to support economic activity.

This is some painful irony. One the biggest critiques of free market counter plans during The Bailout debate was that tax cuts would take "too much time" in recapitalizing the marketplace. Tax cuts would have restored confidence in the market–critical to maintaining stability and fighting volatility–and they would have freed up capital within firms as opposed to giving them cash. How Paulson ever though sorting through the crap load of unwanted mortgage-backed securities to figure out what to buy would have been a quick process is beyond me. Of course that will take a while.

Switching to an equity buy takes on a different set of risk. Instead of taking the bad loans and trying to manage them, the government is just giving banks cash. There are many problems with this, but here are a few key issues:

  • Buying equity in failing banks without demanding some management change is the equivalent of giving a buddy an extra $100 in chips at a poker table when he is down to his last $4 bucks. Sure he might have hit a string of bad luck, but he clearly wasn't managing his bets right, and giving him more money is a pretty big risk.
  • By becoming an investor in the system the government moves from being a referee to an actual player on the field. The government is supposed to set the rules of the game, but if they are engaged in the game too, that will skew the way they set laws and regulations. You can't have the catcher calling balls and strikes too, no matter how unbiased he may claim he will be.
  • Government ownership in banks or other firms changes their management dynamic. They now have to worry about Congress as well as private investors. They have to think like the government with their money and can't be politically biased one way or another with taxpayer money. For instance, if Bank of America gives $1,000 to a political candidate, but is 10 percent owned by the government, then $100 of that is in theory taxpayer backed. The problems with that are obvious. But you can't limit the ability of people, whether through corporate donations or individual giving, to participate in the democratic process. So you can't stop corporate donations all together. Or perhaps a local branch of BB&T Bank gives money to a homeless shelter run by a Catholic church. That branch is participating in community development, but if the government forces BB&T Bank to take bailout money, it is now directing taxpayer money towards a religious operation (set aside that we already do that with "Faith-based initiatives"). There are all sorts of these problems.
  • The partial nationalization of banks will create many opportunities for fraud or fraud-lite. Sure we can stop Senators from demanding interest free loans, but what about the guy who walks into a Citigroup bank for venture capital and happens to mention his uncle sits on a House finance committee? That skews with the operational decision making of the bank in determining that loan.
  • Oh, and, role of government?? Hello?

There's more, but that should be enough to point out buying equity isn't the answer either. Yes, if the banks do better the government can earn a profit (though I don't think the government should be in the business of investing for profit). And yes, at least we're not taking on $700 in bad assets but leaving them in the hands of those who created them to deal with. The equity share is "better" but it is still rife with problems.

Anthony Randazzo is Director of Economic Research


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