Krugman's Capital Injection Scheme: Nice Idea, Won't Fix Problem

by: Matt Stichnoth September 23, 2008    
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Matt Stichnoth

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Paul Krugman and Sebastian Mallaby, among others, both argue that the federal government’s bailout of the financial system should take the form of equity investments banks, not the purchase of troubled mortgage assets. Krugman:

[T]he financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place. 

I almost agree. But the industry’s key problem isn’t lack of capital. Banks have already raised a ton of it—hundreds of billions, at last look. And if the government wants more new capital to flow into the industry now, there are plenty of things it can do (like, say, easing restrictions on private equity investments) to make that happen, short of investing directly.

Rather, the real problem that need’s fixing is the industry’s lack of liquidity--and the capital injections Krugman, Mallaby, and the rest have in mind won’t do much to fix that. Markets will only unfreeze once banks to start to have confidence in each others’ balance sheets again.

That’s won’t happen as long as (thank you, fair-value accounting!) the risk persists that institutions might take further negative marks to their impaired mortgage-related assets. The only alternative, then: those sick mortgages everyone seems to have exposure to have got to go. And the only buyer willing and able to take them in size is the federal government.

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This article has 6 comments:

  •  
    Sep 23 04:07 PM
    Huh? The problem isn't capital it's liquidity? If that were the case then why didn't lowering interest rates to 2% fix the problem? Why did the bailout of Fannie, Freddie, AIG, Bear, et all occur? They collapsed due to massive capital needs that they weren't able to provide, not due to lack of financing. And although there is stress in inter-bank rates there is still financing available, albeit at higher rates. The problem with banks is solvency, not liquidity. This is why none of the Fed's measures have worked and why they are now resorting to massive capital injections by buying up the bank's bad assets.
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  •  
    Sep 23 08:30 PM
    Nonsense, there are lots of buyers willing to take them. The problem is the banking industry thinks they are worth serious money--but instead they are nearly worthless. So the federal government is going to be paying substantially more than the mortgages are worth--in other words giving the most incompetent banks bailouts.
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  •  
    Sep 24 08:55 AM
    Lets see Krugman does not like the plan. Buffet says it will work and may not cost much in the end. Who are you going to believe?
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  •  
    Sep 24 11:45 AM
    While I am a great believer in Buffett I like Krugman's idea. One fact without regulation neither Buffett or Krugman positions offer success. Capital emerges when safety (i.e. regulation) is transparent. I do not see real capital or liquidity being offered by the bailout. I do see the rewarding of greed.
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  •  
    Sep 24 08:46 PM
    The Treasury can loan out money to financial institutions that steered away from toxic assets like the ones causing the need for a bail out. In exchange for nominal interest and tax-exemption from profits associated with purchases from ailing institutions, competent financial institutions can reap profits and help out the US govt.

    The govt can also bail out companies in exchange for an equity stake, but the govt can offer a rebate if returns on such holdings exceed the initial buyout plus nominal interest.

    The government can do what Buffett did for Goldman Sachs, but without the need for high returns. A loan payback would suffice.

    Some mix of different ideas would have to be on the table, because I don't think there is a magic bullet here.
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  •  
    Sep 24 10:53 PM
    Don't think so Matt. Equity provided by government to banks will enhance the latter's solvability and rekindle trust,so that increased liquidity will follow. With banks' reserve ratios not more than 10%, fewer funds will be needed than if government were to buy mortgage related assets under the Paulson plan. With a government equity positions in banks will come the ability to influence decisions on the level and structure of salaries, bonusses and risk management, ie areas where the previous system has failed.
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