A bailout proposal that will work needs to unambiguously address the issue that Secretary Paulson and Chairman Bernanke have identified as the principal threat to our nation's economic well being. That threat has been identified as the unwillingness of banks to lend to each other or to non-bank borrowers. The purported reasons for this unwillingness to lend is that mark to market markdowns of "toxic securities" on bank balance sheets will shrink their equity base, reducing their ability to lend to bank and non-bank borrowers. In addition, markdowns on the balance sheets of their fellow banks who they might lend to will undermine the creditworthiness of those banks leaving the lender bank with a bad loan to a borrower bank.
The solution proposed by Treasury is to create a $700 billion buyer of these "complicated" securities that will cause the market to value these "toxic securities" at a price closer to their "yield to maturity value" rather than the "fire sale" prices that are currently being offered. Becoming the buyer of the last resort for the $14.8 trillion U.S. residential and commercial mortgage market seems to be an extremely indirect way of bolstering the capital accounts of U.S. banks.
A better alternative to the current plan is a simpler and far easier to implement plan that directly addresses the ability of U.S. banks to increase their capital accounts and their willingness to lend to bank and non-bank borrowers.
The proposal is simple. Any "FDIC insured" financial institution in need of capital can raise 10% preferred stock plus warrants (struck at 90% of the prevailing market price/value of their common equity) from the U.S. Government's bailout fund. Generally the same structure and yield offered to Goldman Sachs by Berkshire Hathaway in its recent $5 billion preferred stock issuance. The fund would need only $350 billion to achieve its goal of restarting lending as all FDIC insured institutions had a total of $1.4 trillion of equity capital and only $300 billion of "toxic" mortgage securities on their books as of June 30. This available funding would represent a 25% increase in U.S. bank capital if it was all taken, which is unlikely as many banks have a lower cost of capital even in today's turbulent market. In addition, FDIC insurance rates should be increased to cover any losses that Treasury experiences from institutions that participate and fail in the ordinary course. Additionally congress should consider raising the $100,000 cap on insured deposits to further bolster confidence in U.S. banks, but such an increase is not required to make the program work. This program will be used to stabilize all worthy U.S. banks and will benefit depositors, but not shareholders.
This program is designed to be completely self-funding. In addition, it will allow the holders of these securities, who presumably know them best, to manage and liquidate them at their discretion. It will also hold them accountable for their investment decisions while guaranteeing the financial strength of the U.S. banking system. This program is knowable in scope as all participants are currently regulated and report their assets and capital to their regulators. Additionally, given the fact that only FDIC insured institutions would be participating, any losses incurred in this program (which is unlikely given its design) would simply be reducing future losses that the U.S. government would have had to shoulder if the FDIC insured entity would have failed. Furthermore, the government will benefit the system, probably earn an attractive rate of return and not be exposed to a new bureaucracy with a questionable ability to buy assets of varying complexity and value.
This program will communicate unequivocally to global markets that the U.S. banking system is sound. It will also communicate to FDIC insured banks that in this time of high interest rates for business and individual borrowers and low cost government guaranteed funding, the best thing they can do to quickly rebuild and grow their capital accounts is to lend to creditworthy borrowers.