Many lenders have so much of their capital tied up in mortgage-backed securities or other novel forms of capital that are difficult to value that they cannot attract new capital at a price that would enable the lender to continue in business. The sale of the securities would just expose their lack of value. The federal government, however, has essentially unlimited capital because of its taxing power. It is prepared at this writing to contribute perhaps as much as a trillion dollars to rebuild the capital of the banking industry. The Treasury wants to make this contribution in the form of buying the dubious securities, but that seems to be a mistake, unless pressure of time allows for no alternative. If the Treasury pays the actual value (if anyone can determine what that is) of the securities, it will not be injecting new capital into the banking industry, but merely swapping one form of capital for another. If the Treasury pays more than the securities are worth, then it is contributing capital to the industry all right, but it is also enriching the owners and managers of the banks, which creates the familiar moral hazard problem as well as upsetting people by rewarding careless management practices. The more it overpays, the most costly the bailout plan to the taxpayer.
A more palatable approach would be for the government to drive a Warren Buffett style hard bargain, in which, rather than buying anything from banks, the government would invest in them in a form, such as purchase of newly issued preferred stock, or bonds with a long maturity, that would augment the banks' capital and thus enable banks to make more loans. That would avoid conferring a windfall on the banks by overpaying them for their bad securities; no one thinks Buffett is conferring a windfall on Goldman Sachs. After the industry was back on its feet, the government could sell the bank stocks or bonds that it had acquired.
And the US Senate responds;
Taxpayers should not be expected to pay for Wall Street’s mistakes. The legislation requires companies that sell some of their bad assets to the government to provide *warrants so that taxpayers will benefit from any future growth these companies may experience as a result of participation in this program. The legislation also requires the President to submit legislation that would cover any losses to taxpayers resulting from this program from financial institutions
*In finance, a warrant is a security that entitles the holder to buy stock of the company that issued it at a specified price, which is usually higher than the stock price at time of issue
