Mallaby: This Deal Stinks

Sebastian Mallaby strikes me as a pretty business-friendly, establishment-oriented type so when he says this bailout package stinks I suddenly go from thinking “this smells fishy to me, but maybe these guys know what they’re doing” to “oh shit.” He points to a couple of better models:

Raghuram Rajan and Luigi Zingales of the University of Chicago suggest ways to force the banks to raise capital without tapping the taxpayers. First, the government should tell banks to cancel all dividend payments. Banks don’t do that on their own because it would signal weakness; if everyone knows the dividend has been canceled because of a government rule, the signaling issue would be removed. Second, the government should tell all healthy banks to issue new equity. Again, banks resist doing this because they don’t want to signal weakness and they don’t want to dilute existing shareholders. A government order could cut through these obstacles.

Meanwhile, Charles Calomiris of Columbia University and Douglas Elmendorf of the Brookings Institution have offered versions of another idea. The government should help not by buying banks’ bad loans but by buying equity stakes in the banks themselves. Whereas it’s horribly complicated to value bad loans, banks have share prices you can look up in seconds, so government could inject capital into banks quickly and at a fair level. The share prices of banks that recovered would rise, compensating taxpayers for losses on their stakes in the banks that eventually went under.

Here’s Zingales on “Why Paulson is Wrong.” Here in Vegas, the house always wins, but I at least have a sound understanding of the underlying mechanism.