Bank recapitalization is in the air, which tends to prompt at least two responses: (a) what’s bank recapitalization? or (b) this is socialism!

Bank recapitalization is when an external entity buys new equity shares (stock, as opposed to bonds) in a bank in exchange for cash. The effect is to boost the bank’s assets without increasing its liabilities; since one worry about the banking sector is that it does not have enough capital (that is, it may not have enough assets to balance its liabilities), this is a good thing. (If the bit about capital, assets, and liabilities is confusing, see Financial Crisis for Beginners.) Of course, there’s no such thing as a free lunch, and in this case the bank’s existing shareholders get diluted, because they don’t own as much of the bank as before. But, in general, it’s better to own part of a bank that exists than a larger part of a bank that no longer exists.

Bank recapitalization could be as simple as this: the government (meaning the taxpayer) gets the same kind of deal that Warren Buffett got when he invested in Goldman two weeks ago. In that deal, Buffett paid $5 billion for preferred stock at $123 per share. The preferred stock pays a 10% dividend, meaning that Buffett gets $500 million per year from Goldman’s cash flow. He also got warrants that give him the right to buy up to $5 billion worth of common stock at $115 per share. At the time the deal was announced, Goldman common stock was trading at $125. Even though Goldman closed at $101 yesterday (and has fallen so far today), Buffett is still getting a 10% yield from the $500 million dividend, and if Goldman goes up he stands to make a lot of money from the warrants.

Buffett was able to get this deal because Goldman needed capital and there weren’t many people lining up to provide it. Today, Henry Paulson is in the same situation: as the only game in town, he can negotiate favorable terms for the taxpayer. Note that this does not have the perverse incentives of buying troubled assets, where if he gets a good bargain for the taxpayer, he risks hurting the banks (because they need to sell their assets at reasonable prices to remain solvent). In this case, the bank gets the same amount of new capital in any case, and the only people who get hurt are the existing shareholders. This should also be a relatively easy concept for policy makers to explain to the American public.

Preferred shares are the typical vehicle for this type of investment for two reasons. First, they have superior rights to common shares, so they can have special dividends, and in case of bankruptcy they have priority over common shares (although that may not mean much). Second, they can be designed with special properties. One controversy is whether the government should be able to vote with its shares; many free-marketers think that would constitute undue and risky government interference in actual bank operations. Assuming that is a problem, the preferred shares could be created without voting rights.

Greg Mankiw, former chairman of the Council of Economic Advisors under the current President Bush (and known to generations of students as author of a popular macroeconomics textbook), and no fan of government intervention, has proposed that the government co-invest with private investors like Warren Buffett so they benefit from the same terms that the private investor gets, while avoiding the complications of Treasury negotiating the deal and then controlling a large stake in the bank. While it’s not clear there are any private investors at this moment, this could be a good way to respond to the “socialism” charge.

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