Monday, October 13, 2008

Equity Stakes vs. Buying Bad Assets

There are a lot of policy options being considered, but the two big alternatives are buying equity stakes in banks vs. the original idea of buying bad assets from the banks, predominantly mortgage-backed securities.

Judging from the huge increase in stock prices today, it seems that the market prefers the equity injection (if there was any news today, it was about that -- and the Morgan Stanley deal).

I understand the basic rationale there, that with the normal 10 to 1 leverage of banks, an injection of $100 of equity can support $1000 of new loans.

But will that additional equity be used for new lending, or will it go to just shore up cash on the balance sheet and/or pay off some existing debt? Given the risk aversion of banks right now, who is to say that they won't just buy more Treasury bills with the new cash?

I still like the buying of mortgage assets for four main reasons:

1. It goes to the heart of the original problem, which is uncertain value of banks' assets, and that has caused interbank lending to fall off.
2. It directly removes risk from the banks' balance sheets and thereby stands a good chance of increasing lending.
3. If done by auctions, it will establish prices for all assets in the same class, creating a spillover benefit that helps us sort out good banks from bad banks, even for banks that do not sell any assets.
4. And it still gets cash onto banks' balance sheets, that can be used for new loans.

Of course, these two options are only mutually exclusive in that the Treasury only has $700 billion to play with. Perhaps they will do some of both.

1 comment:

Charlie Danoff said...

Professor Hansen,

Like your insight into the bailout plan, first time I'd read a logical rationale for why buying the bad mortgages makes more sense. Also, enjoyed your wit at the end, though to be fair 700 billion isn't that much money.