On Nov. 12, Secretary of the Treasury Henry Paulson officially abandoned the plan to buy troubled mortgage assets. Instead, he chose to focus on injecting capital (in the form of equity stakes) into troubled banks.
Thus far, $250 billion has been allocated to buy equity stakes in banks in the form of preferred shares. Although the plan has had limited impact on stopping the rapid deterioration of the economy, Paulson has claimed some success in unfreezing the interbank-lending market.
But this narrow-minded plan is likely to be detrimental for taxpayers, homeowners, the long-term health of the economy and even the banks receiving capital infusion.
In buying preferred shares, the government has gotten a relatively unattractive deal. The preferred shares carry an interest of 5 percent and offer warrants for 15 percent of the face amount. This can be compared with the deal that Warren Buffet recently received from Goldman Sachs and General Electric: double the interest rate at 10 percent and the right to convert to common shares for the full face amount.
But an option with a more favorable risk-reward profile was — and still is — available to the government: buying troubled mortgage assets. Currently, many of these assets are trading 30 cents on the dollar. Even if the government were to pay 50 cents on the dollar, it would have a large potential upside because these mortgages are collateralized by homes with an intrinsic value.
According to data released Oct. 28, even the worst real estate markets are down only 36 percent from their peak. The collateral alone is worth much more than the current trading price of these assets. And since not everyone has defaulted, their yield is very high. Combined with a low rate of government borrowing, taxpayers would enjoy a very rich spread while waiting for real estate prices to recover.
This strategy is also likely to have benefited homeowners. The government could have used its position to renegotiate mortgages with people who could not afford to pay them. Keeping people in their houses would have benefitted both taxpayers, by helping preserve the value of real estate, and homeowners, who would not be kicked out.
The long-term health of the economy depends on well-functioning capitalistic markets. School of Management professor Douglas Rae goes so far as to say the death of firms is a defining feature of capitalism. There is a clear conflict, he said, between the an academic justification of laissez-faire policy and the practical need for the government to step in. Using asset purchases instead of equity infusions would have offered a balance between these two goals.
Obviously, without the capital infusion, many more banks would have failed. However, since the government would have created a floor for the assets, bank failure would not have caused systematic shock to the system, further aiding long-term health of the economy.
Bailout in its current form could have also had a detrimental effect on the stronger banks. Several banks have expressed concern that they are forced to allow the government to take stakes in them just to demonstrate to the market that they are financially viable. And since capital infusions came with salary caps, they are likely to drive the most talented executives out of banks and into hedge funds and private equity.
Failure of weaker banks would have also helped stronger banks with new funds in terms of deposits. These, along with cash generated through troubled-assets sales, would have provided banks with the liquidity they needed to start lending again. But banks, paradoxically, have held on to their capital infusions thus far, refusing to lend while borrowing is prohibitively high.
Finally, by buying up troubled mortgages assets, Treasury could have also achieved unfreezing of interbank lending market. Providing a floor for asset prices would have allowed banks to assess the financial viability of their counterparts, making them more comfortable lending to each other.
Jacob Mazour is a first-year student at the Yale School of Management.