Hank Paulson's plan will soon be rammed through Congress, likely with strings attached for "homeowners" and executive pay. Too bad, because the plan is seriously flawed and taxpayers are likely to get hosed. Especially too bad because a much simpler plan that would save the system without socking it to taxpayers.
The main problem with Paulson's plan is this: If the government pays as little for the banks' troubled assets as it should to protect taxpayers (i.e., the market rate), the banks will still be screwed. Why? Because they'll have to raise humongous amounts of new capital to offset the losses. Where is this capital going to come from? Paulson doesn't say.
Under the Paulson plan, the way this problem will likely be resolved is that the government will overpay for the assets--to "save the financial system." In the process, the government will also save two constituencies who deserve no protection whatsoever: bank shareholders and bondholders.
If, in the absence of a bailout, the banks were heading toward Lehman's fate, shareholders and bondholders deserve the same treatment as Lehman's (for equity holders, about 13 cents a share). Under Paulson's plan, these folks may survive merely skinned. Taxpayers, meanwhile, will pick up the tab.
So what's a better plan? Equity infusions.
If/when a bank needs capital, the government should provide it--in exchange for a fair equity stake. Knowing there is an investor-of-last-resort should persuade bank clients to stick around. The taxpayers will then own significant chunks of the banks and will therefore benefit from their recovery. Meanwhile, the folks who are directly responsible for all the crap on the banks' balance sheets--the banks--will still be responsible for sorting it all out. And their shareholders--not taxpayers--would take it on the chin.
And how do you get the banks to act fast on a plan like this? Put a cap on the amount of money you'll shell out. Perhaps the same $700 billion.
Specifically, the government should say, "We're now going to invest $700 billion in private banks. First come, first serve. And if you don't get here in time and you then run out of money, tough beans."
(For a similar view, see Paul Krugman. The NYT columnist and Princeton professor thinks Paulson's plan is a disaster. Senator Dodd's counter-plan includes provisions for the government to receive equity in exchange for the bailout, which makes more sense. It will still require the government to deal with the toxic assets, though.)
