By Peter Boone, Simon Johnson, and James Kwak (pdf version is here)
1. Debt and equity prices for U.S. banks at the close on Friday, November 21, indicated that the market is testing the resolve of the government to support the banking system. Allowing major banks to fail is not an option, as was made explicit in the G7 statement in mid-October. Significant recapitalization will be necessary to stem the pace of global deleveraging (the contraction of loans and sale of assets by banks around the world). However, the administration’s strategy is not clear.
2. While full bank recapitalization is not a panacea, it is an important part of the policy mix that will get us through mid-2009, at which point a broader set of expansionary fiscal and – most important – monetary policies can begin to take effect.
3. The response this weekend by the U.S. authorities in providing financial support to Citigroup is a partial, overly generous, and nontransparent recapitalization, including a large guarantee for distressed assets – which is very close to the asset purchases that Treasury only last week said it would not do. This U-turn confuses the market (again), leaves the fate of other major banks unclear, and implies much larger contingent liabilities and little upside for the taxpayer. This approach will be difficult to repeat multiple times because of likely political backlash.
4. The most important goal now is to put in place a stable, transparent set of rules for bank recapitalization, with sufficient political support and limits on the scope for further policy changes. Mr. Paulson’s seemingly haphazard approach has become a part of the system problem.
5. While all recapitalization options have problems, the “least bad” is requiring firms to raise more capital and, for those that cannot, injecting capital through substantial purchases of common stock by the government. These can be managed through a special purpose agency or control board, which is designed to keep credit from becoming politicized and to sell the equity stakes when market conditions are sufficiently supportive.
6. Another TARP-type round, on slightly tougher terms than October, may serve as an emergency stop-gap measure, but it will not solve the underlying problems and any positive effects could be short-lived.