This [the purchases of the Paulson plan] has the effect of modestly increasing the stated book value of
these financial institutions. More importantly, with the toxic waste
off the books, it improves the likelihood that an outside
investor–Treasury itself, a sovereign wealth fund, even our man in
Omaha–now feels able to value the enterprise. Hold your nose and
admit it: the relatively few franchises that manage the capital
raising and M&A activities of Corporate America are worth a lot.
Said outside investors collectively have enough capital to recapitalize
the major Wall Street insitutions via injections of new equity. Here
comes the tricky part: In exchange for their largesse, both the outside
investors and Treasury (e.g. via warrants struck at the same price as
the outside investor) must be allowed to invest on very favorable
terms. In a perfect world existing equity holders and stock options
would be essentially wiped out, a la AIG. In an even more perfect
world, existing debt holders (i.e. unsecured lenders to Morgan Stanley,
Merrill, etc.) would also take a big haircut, just as they usually do
when corporations declare bankruptcy.
4) Both liquidity and
solvency are restored, credit starts to flow again, and the downward
spiral of asset sales is prevented, allowing whatever pain will occur
to occur over time, and to be spread widely.
…as far as I can tell, the plan does not specify when Treasury
is obligated to buy toxic assets, nor does it prevent Treasury from
doing another AIG. Conceivably it could wait until the maximum moment
of pain to get the best price possible for its assets. Or it could
continue to do AIG-style bailouts followed by purchases of the toxic assets, in a sense bailing out itself.
There is more at the link. A key assumption here is that jump-starting liquidity for bank assets is a big part of the cure; having the government dilute bank equity, as the Elmendorf plan suggests, does not on its own achieve this end. I do find this a reasonable view, though as Paul Krugman points out it is unlikely that it is only a liquidity issue. The implicit belief here is that resolving the liquidity issue is needed to make progress on the solvency issue. Maybe. But still I do not like the Paulson plan. It reminds me of everything I dread about unchecked power and the administration’s score on this question is very, very bad.