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.

You wouldn't know it if you watched the news!

I couldn't agree with you more, Dhakks.

How is free market economics supposed to correct market imbalances if the government bails out corporations every time they mess up? This is socialism for corporations! We either believe in free markets, or not.

Two interesting revelations I came across in NPR:

• The first is that a significant part of Fannie and Freddie's capital is deferred tax credit, i.e. the present value of taxes that won't need to be paid as a result of losses that are carried forward. The problem is that these don't constitute assets that can be drawn upon in case of a crisis like this. Which basically means that the crisis was much more dire than imagined at first.
  

• The second is that the combined outstanding debt of Fannie and Freddie is roughly $5 Trillion. Yes that's trillion, not billion. That is more debt at stake than any company in history. It's more than the debt of every country in the world except the US. Hell, its more than the GDP of every country in the world except the US. In fact, the crash of the Japanese economy would arguably be less of a strain on the world economy than Fannie and Freddie.
  

The aggregate cost of this debacle to the tax payers depends on how much of the loans will actually prove to be bad. Estimates range from $25BN to $200BN.

What has astonished me today is that effectively the US government has taken on $5 trillion in credit exposure upending a fundamental argument made by Reagan when privatizing these behemoths. The world, by general consensus, just avoided what is possibly the closest it has come to a global financial meltdown since the Great Depression, and the news has focused on lippygate and Lou Dobbs spent an hour on a tirade against illegal immigrants. This is surreal!