Paulson’s New Bailout Plan: The Trouble With Owning Bank Shares

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Henry Paulson watched the Brits come up with a new plan to save the banking system before he did. He is probably embarrassed by that. He and Bernanke seemed to have a big lead over everyone else in building Lego models for saving the financial world.

The latest idea if for the Treasury to actually buy equity in banks thereby mainlining capital into large financial institutions in the hope that they will then lend that money out.

It would be a fabulous and daring program if it made any sense. According to The New York Times,"Having tried without success to unlock frozen credit markets, the Treasury Department is considering taking ownership stakes in many United States banks to try to restore confidence in the financial system."

The share that the federal government has taken in AIG (AIG) shows just how well thees plans works. In exchange for an $85 billion loan, the taxpayers own 80% of the giant insurance company. That arrangement dissolved into chaos about two weeks into it implementation. AIG management had to telephone federal officials and ask for another $37.8 billion. They got it, because the Fed cannot afford to see its initial investment fail.

Across town at the talks for Citigroup (C) or Wells Fargo (WFC) to buy Wachovia (WB), word is that in due diligence the Wachovia assets look worse than expected. That may mean that no one wants to buy the troubled bank or that the FDIC will have to guarantee some of the assets. The pulls the government further into the mess in yet another transaction.

Paulson would like to own a percentage of major banks, but some of those major banks may fail. So, Treasury can put up more money to save them, of watch its investment go to zero. At least if it only buys toxic assets off balance sheets it will have something to show when the paper matures. Perhaps taxpayers will actually get their money back.

The government is being pulled deeper into a violent whirlpool. It will end up owning banks, Fannie Mae (FNM), Freddie Mac (FRE), AIG (AIG), and bits and pieces of the rest of the financial system. As these go through serial failures someone has to come up with more cash. Or, the Fed and Treasury can just write much of their investments off.

Douglas A. McIntyre