We now have yet another switch in the Treasury's strategy for stabilizing the markets. Plan A with the $700 billion rescue plan was to use the money to buy some of the questionable mortgage-related securities that are held by the nation's troubled financial institutions. Treasury Secretary Hank Paulson now wants to take a direct stake in the banks, to buy stock rather than simply buy some of banks' assets.
The most obvious reason for the shift is that, unless the government overpays, buying a bank's questionable securities doesn't necessarily improve its balance sheet. It replaces one asset- the securities- with another one- cash. If the government buys stock, on the other hand, the cash directly increases both the bank's assets and its net worth, potentially increasing the likelihood the bank will remain solvent.
That's the good news. But there are at least two potential problems.
One is the obvious risk that government ownership would distort the decision making of both the government and the banks going forward. This is indeed a scary prospect. Paulson has suggested that the government will buy nonvoting preferred stock, to reduce the ability of the government to meddle in bank decision making. That's better than having the government vote on bank decisions, but it still leaves the government tied at the hip to the banking sector.
The second problem has gotten less attention: which banks' stock will the government buy? If the government buys the stock of banks that are struggling because they leapt into the subprime mortgage market and now are incapable of surviving on their own, it is rewarding precisely the banks that least deserve help. More likely Paulson will try, at least to some extent, to target good banks- banks that are viable though struggling- and to do what Warren Buffet did with Goldman Sacks- signal confidence through the willingness to invest. The danger with this strategy is that it could set off a political scrum, as banks lobby heavily for government investment for fear that the banks that are left out will be viewed as losers by the market. The negative signal of being passed over by the government could be devastating.
It is perhaps worth noting the new Paulson plan is quite different from John McCain's proposal to buy up mortgages and renegotiate them. McCain appears to be proposing that the government buy up troubled mortgage securities at 100 cents on the dollar, then restructure the underlying mortgages. This is a little like the old Paulson plan, except that banks would receive full payment for their mortgages, rather than the lower values they're actually worth. (Thus, the government would deliberately overpay). This plan would thus help the banks' balance sheets. It also would help homeowners, since their mortgages would be restructured. Neither the old nor the new Paulson plan paid much attention to the plight of homeowners. One downside of the McCain plan, in addition to the potentially enormous cost, is that it would reward banks for their involvement in mortgage related securities.
The title of this post is, in a sense false advertising, to the extent it suggests I know the right strategy. I don't. I think my choice would be to swallow my doubts about government ownership, support the new Paulson plan, and combine that with the bankruptcy reform (which I've defended before) that would allow borrowers to write down their mortgages in bankruptcy. I'd be interested to hear what others think.