Why equity infusion is better than buying bad loans

I was recently in a conversation about whether buying defaulting debt and investing in equity had the same effect. The answer of course is no. Let me explain.

Let's say we have a hypothetical bank. The bank makes a bunch of loans whose value is $100. So, the assets of the bank are now $100. Meanwhile, the bank funds these assets with 90% debt and 10% equity. So, the bank has $90 in debt and $10 in equity.

Now, if say $20 in loans were bad. Then the bank can sell the $20 in loans at market value to the government under the original Paulson plan. What would happen, therefore, is that the bank would have an asset side of $100 and a liabilities and equity side of $100. Let's say the actual worth of the $20 in loans bought by the government is $10. The immediate cost to the government was $20, with $10 of that being recoverable in future. So, the government is set to make a net loss of $10. The balance sheet of the bank remains unaffected, except that $20 in bad loans got replaced with $20 in treasury bills. What this plan did, was to prevent the loss from affecting the equity of the company. It was a bailout - transferring the banks loss to taxpayers. The bank could sell the $20 in treasury bills and lend it out, creating $20 in additional liquidity.

In the equity infusion plan, the Government could give the bank $20 in equity. The company would need to write down its loan values by $10 (remember the $20 of bad loans are actually worth $10). So, what happens is that the company now lands up with $20 in equity ($10 of the original equity + $20 from the government - $10 loss recognized). Of course, banks tend to leverage up. So, if the bank continued to maintain the same debt to asset ratio of 90%, it would mean that the debt portion of the bank could now be $180. They only have $90 in debt at the moment, so the bank can now borrow and lend an additional $90. This would be in addition to the $10 that it received from the government net of losses. If interest rates go down, then it's possible that the loans would appreciate in value and the government could make back some if not all the losses. However, given the toxic nature of the loans, its unlikely that the government would turn much of a profit.

So, the ending balance sheet in the equity infusion approach is that $20 in equity, $180 in debt, and $200 in assets. The effect was: (a) that the company was forced to absorb its own losses, (b) there was huge capital infusion into the system ($100 in this example), and (c) the cost to the government was the same, but instead of a likely loss, the government now holds $20 in stock in the company which will probably make the government a tidy profit at the end of it.

Net-net, buying bad mortgages is not good for the tax payers and doesn't induce much liquidity. Putting the money in equity infuses significantly more liquidity while protecting shareholders.