Throwing an unprecedented $700-billion (U.S.) at the U.S. financial system should fix U.S. banks, but it won't rescue Wall Street in the traditional sense of the word.
Nor should it.
The Bush administration unveiled the broad strokes of bailout Saturday, with plans to buy billions of dollars worth of distressed mortgages and other debt from American lenders, including the Wall Street investment banks and global commercial banks such as Citigroup.
The package itself was no surprise, as it has been taking shape since Thursday. The real question here is one of price. Will the U.S. taxpayer buy toxic mortgages derivatives from banks and dealers at 2 cents on the dollar, or 20 cents, or 100 cents?
Or asked another way: How much pain must the U.S. taxpayer absorb to save Wall Street from itself?
It's the formula for the bailout that will determine what happens to shares in America's banks. While details remain unresolved, look for a very smart and very angry U.S. Treasury Secretary Hank Paulson to make this rescue plan a putative exercise for financial institutions.
And that means Morgan and Goldman and Citi may not be out of the woods, from the point of view of their shareholders.
These institutions, and other banks, should survive. But if Mr. Paulson gets the rescue package right, iconic dealers and big banks may well need to more capital, and raising that cash will mean real pain on their existing shareholders.
The terms of this bailout can easily be tweaked to ensure a fair portion of future losses on bad loans are shouldered by bank shareholders. That approach would be good public policy.
As one hedge fund manager put it on Friday, Mr. Paulson needs to take the Goldilocks approach to spending that $700-billion.
Offer terms on the bailout that are too generous, and Washington is subsidizing bad decisions by some of the world's richest individuals on Wall Street, at the expense of taxpayers. Make the bailout too mean, and the entire banking system fails.
But get this bailout priced right, and shareholders bank and investment dealer shareholders will learn a nasty, expensive lesson in risk management, while the financial system continues to function. In time, the U.S. taxpayer might even make a few bucks on the $700-billion portfolio that will be assembled in coming weeks.
So to use another storybook metaphor, Mr. Paulson shouldn't be trying to put Humpty Dumpty back together. Making lenders whole on all their stupid loans would be nothing short of obscene.
Mr. Paulson's goal should be a rescue that punishes those banks forced to sell their mortgage-related debt to the government. There should be real pain for financial institutions forced to ask the U.S. taxpayer to pay for their incompetence.
The tone of U.S. Treasury Secretary's remarks on Friday speaks to that mindset, to the same approach that virtually wiped out Bear Stearns equity holders when that investment bank was sold to J.P. Morgan in a government-arranged marriage.
Mr. Paulson, former head of Goldman Sachs, is deeply concerned about moral hazard. He doesn't want his political legacy giving Wall Street firms a heads-you-win, tails-I-lose taxpayer bailout. (He's said he's done in Washington after the November's presidential election.) A press release Friday from the Treasury that preceded the rescue plan by a few hours said: “Lax lending practices earlier this decade led to irresponsible lending and irresponsible borrowing.”
Ask yourself: Are the owners of banks that have been labelled “lax” and “irresponsible” going to be made whole at the expense of the taxpayer? Not likely.
