Less than a week after pulling off the media coup of publishing his universal credit insurance proposal in both the FT and the WSJ on the same day, Ricardo Caballero has a new proposal for solving the banking crisis, this one in tomorrow’s Washington Post.
He should go back to the last one.
Here’s the new proposal: “The government pledges to buy up to twice the number of bank shares currently available, at twice some recent average price, in five years.” According to Caballero, this will have the following effects:
- Because bank stocks immediately become more valuable, it has a wealth effect that pushes up the value of all assets.
- Banks will be able to raise private capital, because they can issue additional shares equal to all of their outstanding shares, and these shares will have a price floor.
- Because this will have a stimulative effect and will solve the bank capital problem, the economy and the banking sector will go back to normal, and five years from now the government won’t actually have to buy any shares, because they will be trading above the government-guaranteed price floor.
Let’s start with the most important issue: fixing the banking sector. Caballero’s credit insurance plan would solve this goal, because it involves cheap government insurance for all bank assets. This proposal, by contrast, is a private sector recapitalization plan. Essentially, each bank would be able to raise new capital (by selling shares) equal in value to twice its current market capitalization, because those shares are guaranteed. For Citigroup, that would be about $20 billion. Does anyone think that would be enough to lift the clouds hanging over Citi? JPMorgan, by contrast, could raise about $150 billion. But there’s nothing saying that they have to, and bank managers who think that twice their current share price is still undervalued will have no new incentive to raise capital.
This is especially true because of the perverse incentives this plan creates, which make it especially hard to understand. This plan creates a government guarantee on the stock price. In other words, it says, “No matter how stupid you are, what ridiculous risks you take, and how bad your bank is, we will buy your stock at an artificially inflated level.” Is this really the way to create a healthy banking system? I understand why people are afraid of government control over banks, but this seems at least as bad to me, since it creates an obvious incentive to take excessive risks. In addition, this takes away the usual incentive for raising capital: the need to maintain capital adequacy levels. Now that the government has guaranteed that shareholders will not lose their capital, no matter what, why raise more and split the upside with new investors?
What about the stimulative effect on the economy? Basically bank stocks would double in value overnight. Now, the S&P 500 Financial Sector Index is down about 80% from the summer of 2007; banking stocks are probably down a little more, say 85%, and insurance stocks down a little less. So the day after this plan is announced, your bank stocks – by now a small part of most portfolios – are down only 70% instead of 85%. While this might have some wealth effect, I think it would be relatively small; among other reasons, stock holdings and retirement accounts have a relatively small impact on consumption, compared to wages, dividend and interest income, or even home values (because they can be used for home equity lines). And I don’t see how it could turn around the economy.
Besides, if the idea is to stimulate the economy by making people feel wealthier, the simplest and fairest way to do this is through a tax cut. But the problem with tax cuts right now is that most of the tax cuts will simply be saved. This should be even more true of the Caballero plan, which just makes your banking stocks double in value. And if we are looking for creative ways to make people feel wealthier, what about a government guarantee to buy your house, in five years, for whatever you paid for it? (That was a rhetorical question.)
But, Caballero says, the great thing about his plan is that it is free. Because the plan will turn around the economy and return the banks to normal, the government will never actually have to buy the shares. This is wishful thinking in its most pure form. Yes, it is possible that if we fix the banking system, the economy will turn around, and most of these troubled assets will return to something like their current book values. But in that case, every proposal anyone has offered will turn out to be free. Caballero’s credit insurance plan will cost nothing, because the government will never have to cover any losses. Paulson’s plan to buy toxic assets will cost nothing, because those assets can then be sold for more than the government paid. The nationalize-reprivatize plan will cost nothing, again because the the government can sell the bad assets at a profit. Buiter’s and Romer’s “good bank” plan will cost nothing, because the good banks will be worth more than the capital it takes to set them up. A government recapitalization plan – say, for example, the government buys, at twice the current price, a number of shares equal to the current shares outstanding, will cost nothing, because the government’s new shares will be worth more than it paid for them. (This is similar to Caballero’s plan, except we know that the banks will actually raise capital, and the taxpayer gets the upside as well as the downside.)
But as Martin Wolf put it in a post I’ve recommended before and recommend again, “the heart of the matter . . . is whether, in the presence of such uncertainty, it can be right to base policy on hoping for the best.” That question answers itself.