Bailout Should Have No Strings Attached

Bailout or not, the devil is, of course, in the details. Details like, at what price?

Jake at EconomPic offered an excellent insight on how the bailout plan may result in banks waiting for others to sell to the government first, thus exacerbating the logjam. It goes like this: whoever sells to the government first establishes a price, then others are better off selling at the price in the open market, avoiding penalties such as regulation, compensation cap, and equity dilution.

I'd like to expand on this arbitrage argument, but from another angle. The above analysis means there'll be a premium for selling to the government as opposed to the open market. Based on this argument, one could argue that, the fewer strings attached to the bailout, the smaller the taxpayer premium. I assume this is the argument behind Paulson's objection to any and all costs to the banks opting in the bailout.

As much I resent the bailout idea, this is a valid argument.

But another factor makes the argument even stronger: cost of carry. Whoever decides not to sell to the government or buy from the open market will have to pay cost of carry and take the risk. Risk is obviously very high, even after the bailout provides a backstop, but it's equal for everyone. The cost of carry to a large degree depends on the financial health of the bank. The more desperate the bank, the higher the cost of carry.

Therefore, shaky banks are more incentivized to sell to the government, while healthy ones could afford to hold out more and/or longer in order to avoid the bailout penalty. In other words, many strings attached to the bailout would only result in the taxpayer bailing out the the most shaky banks. This is exactly the opposite of what it should achieve: save the healthy and let a few sick ones perish.

Now this sounds really bad. The bailout idea itself is bad enough to begin with. Now it should not have any strings attached?!

Yes, I mean, no, no strings attached. Just with a bit of the usual bureaucratic delay. But since it's such unnerving times, I say we should specify the delay -- say, one week?

But it doesn't mean taxpayers must be suckers. This is how I would design it: I buy from banks at market price (e.g., average price of the day) plus some nominal premium, say, one week Libor plus 10 bps.

How would this help? The moment the government announces this execution plan, the market will thaw, because there will be people able to buy from the market, pay the cost of carry for a week, and then sell to the government. Who can afford to take advantage of the 10 bps premium? Those with enough liquidity and healthy balance sheet. The desperate ones could sell to the government and/or the market. The only difference is that government is slower. If you can afford the delay, you get to make the extra 10 bps.

The result is the best of the bunch will join the rescue, while the worst ones will provide liquidity and upside pricing pressure to the market, depending on their desperation.

If we have to do a bailout, this is the least costly, most sensible way of pricing it.