Good Lord, the Treasury sure is resourceful when it comes to dumb ideas. Or, rather, it keeps insisting on rolling out the same rejected ideas under different names, in the hope that somehow one will escape attention and kick the problem down the road.
The latest iteration is the idea that the way to inject new equity into the banks is to convert the government’s preferred shares into common shares.
In a significant shift, White House and Treasury Department officials now say they can stretch what is left of the $700 billion financial bailout fund further than they had expected a few months ago, simply by converting the government’s existing loans to the nation’s 19 biggest banks into common stock.
Think of it like Feeding the Multitude, with Baghdad Tim, Larry Summers, and a whole lot of accounting tricks in place of Our Lord. Without introducing any new capital, the banks are magically better capitalized.
Of course they aren’t.
The government’s fallback claim is that they are focusing on tangible common equity, not Tier One capital, and therefore capital ratios really do change. But who decides what to focus on? If the government decided that one aspect of a well-capitalized bank was a purple logo, changing logos to purple really would bring banks closer to compliance. But it would most certainly not bring them any closer to solvency.
Buiter, constrained by intellectual honesty that plainly does not afflict official Washington, had this observation last week:
At that point, only the ‘good bank solution’, which requires either a serious hair cut for unsecured creditors or a mandatory conversion of debt into equity will be viable, simply because the bad bank solution requires additional public money which isn’t there. (You creating a new good bank out of the assets of the old bank and the insured deposits and counterparty claims on the old bank, leaving the unsecured creditors of the old bank with a claim on the equity in the new good bank; a bad bank requires funds to buy the toxic and bad assets from the old bank and addition resources to capitalise the bad bank).
We will have wasted a lot of time – the good bank solution and the slaughter of the unsecured creditors should have been pursued actively as soon as it became clear that most of the US border-crossing banking system was insolvent, but for past, present and anticipated future tax payer support. If the Treasury can be pushed into a pro-active policy by declaring, just before the beginning of the weekend, that most of the banks undergoing the Stress Test have failed them and moving these wonky institutions straight into the FDIC’s special resolution regime where they can be restructured according to the good bank model, we could have well-capitalised banks capable of new lending and borrowing by the beginning of next week.
The same policy should be pursued wherever banks have failed: it never makes sense to put the interests of the unsecured creditors before those of the tax payers. It is bad economics in the short run and in the long run. And it is political poison. I fear, however, that only in those countries where there is no fiscal spare capacity (as in the US, for political reasons or in Iceland, for economic reasons), the right solution to bank restructuring will be adopted. Elsewhere the unsecured creditors will continue to feed off the carcases of the tax payers and the beneficiaries of public spending programs that will have to be sacrificed to foot the bill.
How he underestimated Baghdad Tim…
Moreover, some otherwise sober commentators actually seem taken in by the idea. We have Matthew Yglesias and James Kwak saying that despite the obvious rearranging of deck chairs, they would just as soon do it.
Why would we want to buy any common equity in the banks? Think of this as a line for concert tickets – all we have done is swap places with the guy behind us. We haven’t added any seats, we haven’t made the band any better, we have just ensured that some other guy has a positional advantage over us.
Bad enough we did not immediately implement the Bulow Plan. Why compound the problem by cramming ourselves into the most junior security? We can be fairly confident the conversion ratio will be unfavorable to us. And more simply, it brings us to a terrible moment that no one seems willing to acknowledge:
When we cross 50% ownership (and certainly as we approach 80%), the creditors of the bank holding companies will assert that the bank holding companies are subsidiaries of the Federal Government and the debt of the bank holding companies is an instrument of the Federal Government. Voila, the only real solution to this crisis – the conversion of bonds to some sort of equity risk, either explicitly in a cram-down or implicitly in a scenario where the debt rides with a “bad bank” – is precluded and the taxpayer is on the hook for every moronic CDO ever written.
AIG is already an object lesson that the government is in for a penny, in for a pound; we are politically no more able to admit a loss and move on than a raccoon holding a baited trap is able to summon the will to let go and release its leg. Taking the common equity and seats on the board will make us permanent hostages to the historic form of the money center banks. Let go.
