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TPM Reader IA responds to TPM Reader PS on the ‘bad bank’ idea …

PS’s claim that the model currently being proposed has a way of protecting taxpayers from over-paying for illiquid assets fails to consider that the current market price would do more than dilute existing shareholders. For many banks, it would wipe them out and force debt holders to absorb significant losses as well. So the idea of giving government an equity stake in an insolvent company in return for over-paying for toxic assets is really a gift to debt holders. (This is why Bill Gross is so positive on the plan.) Like shareholders, they knowingly took risks when investing in these companies in search of higher yields. Why should they not be forced to take a hit?

One point that might be worth considering. I’ve heard that a number of sovereign wealth funds — i.e., foreign governments who’ve invested big chunks of money — have put us on notice that they would not sit still for seeing their own assets wiped out in any global financial sector plan.

And TPM Reader TP follows up …

Reader PS assumes that banks aren’t lending because they have all of these assets of “uncertain value” on their books.

Krugman has already addressed this argument and the “folly” of the ‘Bad Bank’ that is ‘Bad’ for you (the taxpayer) and not-so-bad for the ‘Bank’ after all. As Krugman has pointed out, the problem is a “Zombie Bank” problem. There are doubts about the solvency of many banks. This means that the problem is that these banks can’t attract private capital (debt or equity) because investors and creditors fear throwing good money after bad. What PS describes is not a “sale” of these assets but the exchange of these assets for some type of warrant or future claim on equity. It’s pretty clear that these assets are not being carried at anywhere near expected value. If the Gov’t takes these assets in exchange for what is expected to be a large issuance of shares in the future (and the Gov’t must pay much more than what the banks think the assets are worth, otherwise there wouldn’t be any improvement to the capital base), wouldn’t it be difficult for these same banks to raise equity capital? Who wants to own Bank X at $4/share with the expectation that it will be massively diluted? Similarly, who would lend to this bank that can’t raise equity and whose ratings will remain uncertain until the Gov’t’s claims are known?

Meanwhile, business as usual for the bank managers and employees (the folks with whom Gheitner is most familiar). The bonus party goes on (see: Merrill Lynch, AIG) while the equity holders languish in uncertainty and the taxpayers pay the bill. Oh, btw, isn’t there another financial instrument that gives you cash now but may be converted to stock in the future? Doesn’t that instrument earn a pretty nice rate of interest (ask Mr. Buffett)? I don’t think we’ll be seeing that kind of return on the ‘Bad Bank,’ do you? That would be another taxpayer-funded subsidy.

This is an uncomplicated game of “hide the salami.” It may very well be appropriate for Obama and the Congressional Dems to bailout the poor judgement of Wall Street shareholders and employees, but we shouldn’t kid ourselves into thinking it will be anything but massively expensive to the taxpayer. The ‘wisdom’ isn’t hidden here, the bill is.

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Josh Marshall is editor and publisher of TalkingPointsMemo.com.
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