Votermedia Finance Blog

October 14, 2008

Should the U.S. buy preferred stock?

Filed under: Uncategorized — Mark Latham @ 11:50 am

With $700 billion of U.S. government funds approved for stabilizing financial firms, there has been much debate on how best to use it. The original Paulson proposal called for buying distressed assets. Many have pointed out that if the government pays fair market prices for these assets, then it won’t make financial firms any more solvent. If more than fair market is paid, then it’s a giveaway of taxpayer funds to poorly managed firms. See for example Diamond et al; and Krugman 45 minutes into the Princeton panel discussion.

There are more effective and fairer ways to strengthen balance sheets. The Treasury plan has now shifted toward a growing consensus view (shared by Diamond, Krugman, the UK government and many others) that the U.S. government should buy preferred stock in troubled firms. $250 billion has now been allocated to that strategy.

I agree that buying preferred stock is better than buying distressed assets. But I think we can do much better yet. Here are three problems with buying preferred stock:

  1. Like the earlier proposal to buy distressed assets, these are non-market transactions between the government and private sector firms. The government is likely to overpay, thus giving away taxpayer funds to poorly managed firms. There is likely to be corrupt influence on the terms of these transactions.
  2. Ongoing government ownership of substantial equity stakes (preferred or not) is more likely to worsen corporate governance than to improve it. The connection between those whose money is at stake (taxpayers) and those who administer the government-owned shares (appointees) is very weak and indirect. Again, this invites corrupt links between government appointees and firm management, harmful to the interests of taxpayers and shareowners. While corporate management’s governance track record has been disappointing, government’s track record has been worse. (As an example, I would mention the policy of guaranteeing risky mortgage loans.)
  3. Buying enough preferred stock to strengthen financial firms’ balance sheets would use up $250 billion much faster than a strategy of injecting capital then selling securities to the market, which releases funds to use on the next firm.

To bring these issues into sharper focus, what if the government buys some preferred stock as proposed, then immediately sells it on the secondary market? This would still leave the firm with its strengthened balance sheet, while solving problems #2 and #3 above. But it would highlight problem #1, if the sale proceeds are less than what the government just paid the firm, which is almost certain (else why wouldn’t the firm have issued to the market directly?).

For example, suppose the government buys preferred stock from the financial firm for $10 billion, then sells it on the market for $8 billion. Then taxpayers are giving the firm $2 billion so as to persuade it to issue $8 billion worth of preferred stock. Why is this taxpayer gift necessary? Why won’t firms issue stock voluntarily, to give their balance sheets desperately needed strength? There are several factors in play here; I would beware simple answers. More on this in later posts.

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