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Paul Krugman says "Yo' mama"

a little night musing's picture

Explaining why the latest floated plan from Obama's "top economic advisors" (is that you, Timmy and Larry?) doesn't make sense.

The proposal is to "stretch" (the NYTimes' word) the bailout funds by converting the existing loans to the biggest banks into common stock. This turns the loans into capital for the banks, thus improving their balance sheets, and good things ensue (or so we are told). Because, uh-oh! the stress test are expected to show that some big banks, including my own personal parasite BoA, are in need of more capital. (I know the feeling!)

Quoth the Times:

While the option appears to be a quick and easy way to avoid a confrontation with Congressional leaders wary of putting more money into the banks, some critics would consider it a back door to nationalization, since the government could become the largest shareholder in several banks.

If it's a backdoor to nationalization, hey, I'm all for it! But if not, well, there is of course a downside:

Taxpayers would also be taking on more risk, because there is no way to know what the common shares might be worth when it comes time for the government to sell them.

[Also, and I may be remembering this incorrectly, but weren't these loans no-recourse loans* in the first place, meaning that there's come risk even in leaving them as loans? Or am I thinking of something else? Can someone help me out here?]

Anyway, that guy with the Swedish prize comes in to put his finger on what's bothering me the most about this plan:

Fisrt of all:

OK, I don’t get the latest bank-rescue idea: converting TARP preferred shares to common equity. It really does seem to fall into the shuffling-the-deck-chairs category.

I didn't quite get the rest of that discussion, but fortunately Krugman soon came up with an analogy that clears things up for me: [quoted pretty much in its entirety]

Here’s how I think about it: you started a business with a bunch of borrowed money, but of course had to put some of your own money in. Now, actually some of the money you put in was borrowed from your mother, but the original lenders don’t care about that, since they have prior claim.

Eventually you run into some business difficulties, and your creditworthiness is in doubt — which in turn is making it hard for you to do business. What you need is evidence of ability to repay the money you already owe.

So does it help if your mother converts her loan into a share of the business? Not really, because she won’t get repaid anyway unless all your other creditors get paid first. So the terms of her agreement with you don’t affect their prospects of payment.

And in this case, the TARP is your mother.

That was pretty much what I was thinking when I read the plan, and I'm no economist or financier. If this analogy is correct, then I have to wonder what this proposal is all about.

*[If I'm wrong about these being non-recourse loans, then the point might in fact be to move more risk to the taxpayer side...]

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