Categorized | economy

Fama on the government’s bank bailout

Because of the “debt overhang” problem, the bailout is in part a subsidy paid to the bank’s debt-holders and represents a real loss to taxpayers. The better solution, according to Fama, is to use FDIC-type powers to punish bank stockholders and debt-holders:

The FDIC’s powers are written so that taxpayers should not have to pay when a bank goes bad. The logic is that the bank’s stockholders and its lower priority debt holders get the benefits when the bank does well so they should pay the costs when it does poorly. Stockholders and lower priority debt holders should be pushed out of the game until the value of the bank’s assets are sufficient to cover its remaining liabilities. My view is that this blueprint should be followed when the subsequent injection of equity capital that a failed bank needs to survive comes from the public sector (the Treasury or the Fed), as well as when it comes from the private sector. It produces all the benefits of a recapitalization without a taxpayer subsidy.

Pietro Verenesi and Luigi Zingales at the University of Chicago in their paper, Paulson’s Gift, estimate the total cost to taxpayers of the first $125 billion investment by the government under TARP to be $112-$135 billion:

By computing the value of the preferred equity and the warrants the Government will receive in exchange for the $125bn investment we obtain an estimate between $89 and $112 bn. Hence, the equity infusion costs taxpayers between $13bn and $36bn. We also estimate the cost of the debt guarantee extended by the FDIC on all the new bank debt to be worth $99bn. This brings the total taxpayers’ cost at between $112bn and $135bn. Hence, in the banking sector the plan destroyed between $3bn and $26bn.

What this means is that of the initial $125 billion, somewhere between $13 billion and $36 billion went straight to the folks holding debt owed by the banks. This is like buying stock and, almost the instant you buy it, the value of your stock drops 10%-30% (because the money you pay for stock goes to pay off debt immediately). No rational investor would buy stock that instantly lost that much value overnight. That, of course, is why taxpayer money had to be used.

After comparing the revised Paulson plan to the original and two other alternatives, Verenesi and Zingales conclude:

We analyze the market response to the revised Paulson plan and show that, possible systemic effects aside, this plan does not create any value in the banking sector: it amounts to a massive redistribution from taxpayers to bondholders. While this finding does not reject the possibility that the plan could have been successful in helping the economy, it questions the channel through which this could have occurred.

We then study the cost of alternative plans that would have achieved the same systemic effects in terms of reduction of the default risk of existing banks. We find that the revised Paulson plan is the most expensive for the taxpayers, second only to the original Paulson plan. The only reason to prefer it to a simple equity infusion would be to reduce the Government’s ownership of banks by five percentage points. But this goal cost taxpayers an extra $72bn, roughly $700 per family.

In a previous post, I ask the question if easing regulatory restrictions, such as the mark-to-market asset valuation rules, can achieve the same results without costing taxpayers money. This is especially important now that we know that Treasury is proceeding with the attitude that money can be burned. As The Joker says, “Money doesn’t matter, you have to send a message.”

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