04 October 2008

Will Government Force Banks to Accept Bailout?

One question that has me perplexed by the (latest) government bailout plan is exactly which institutions would want to take the treasury department up on its offer of buying dud assets? My understanding is that in order to tap into the government funding the lenders will have to 1) agree to executive salary restrictions and 2) offer warrants to the government (there is even a provision in the bill that allows the treasury to demand stock in exchange for the financial help, but it isn’t clear if the treasury will exercise this right).

With terms like this, which financial institution would really want to avail itself of government help? Any CEO who accepts this deal will essentially be ending their career and the shareholders likely won’t be too thrilled with the potentially dilutive impacts of the warrants. Logically, it would seem as if most financial firms would rather just hang onto their toxic assets, and hope that the bailout ends the crisis and markets for these dubious goods return (at prices they like). After all, if the government manages to put a floor on prices for shunned credit instruments then why does it matter if they sell them or just keep them on the books, the end result is the same (i.e. they book the same price either way)?

This all assumes that the treasury was even willing to offer near full value prices for these assets in the first place. If the government somehow tries to offer a significant discount from face value (albeit still above actual market prices) then virtually no one would be interested in the bailout. For most institutions accepting any kind off significant price cut would render them immediately insolvent.

It all boils down to this: accept the bailout and lose your job and accept the potential of wiping out shareholders or hang on hoping that somehow markets recover. This really doesn’t seem like much of a choice. What manager would take the altruistic stance that it was ultimately in the best interests of the economy to restore the company to health even if to do so would hurt themselves (and existing shareholders)?

So what’s the government to do? Are they going to have to resort to forcing struggling financial institutions to accept the bailout?

Of course, even if the demand for access to bailout money is substantial, we have no guarantees that the credit markets will unfreeze. No bailout will change the fact that tens of millions of Americans can’t afford their debt payments and that default rates will continue to increase. Until all those defaults have run their course the underlying asset prices (e.g. mortgages, credit card and auto loan receivable securities, etc) will continue to fall, which will force lenders to continue ratcheting up lending criterion and terms. Why accept 10% down for a mortgage when there is a good chance the home will drop another 10% in the next year?

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