If the taxpayers give better terms to troubled financial institutions than Warren Buffett would, things will get worse instead of better.

Warren Buffett's Berkshire Hathaway will invest $5 billion into Goldman Sachs in exchange for cumulative preferred stock paying a 10% dividend and 5-year warrants that would allow Berkshire to buy $5 billion of common shares at $115 per share (which is $10 below the current market price), according to this story. Goldman is pretty healthy, as evidenced by its share price, but even so it had to pay a pretty high price for this new capital.

If the taxpayer bailout plan being negotiated in Washington offers better terms to troubled financial institutions than Berkshire or other cash-rich firms and funds will offer, the flow of private money into these firms will stop. Instead, all of the troubled firms, and many that are not troubled, will run to Uncle Generous for an injection of cheap capital. In other words, any taxpayer bailout plan would be in competition with private investors, and if the taxpayer plan is too generous it will completely displace private investment. Not what we should want.

Bruce McF has a detailed plan and useful analysis of the financial crisis here. In essence, Bruce proposes creation of a permanent public trust to purchase toxic assets and pass through all dividends and gains to the citizens. Pricing discipline would be imposed by the requirement that the Trust buy $1 of preferred stock for every $1 of toxic assets purchased. Preferred stock issues typically provide that if the dividend is not paid on time the holders can step in and assert a lot of control. For example, Bruce would provide that a default would invalidate all executive severance packages. In principle, other prudential triggers and other remedies could also be included. I like the concept, better than the others I have linked here, but I fear any federal bailout may prevent private capital from solving the problem.

Update on Thursday, September 25, 2008 at 10:36AM by Skeptic

James K. Galbraith says here we can address the whole banking problem with more extensive deposit insurance, audits, and case-by-case bridge loans and preferred stock puchases.  He makes the excellent point that nobody should worry that banks are holding "illiquid assets," because banks hold illiquid assets all the time--they're called "loans."  Galbraith would require hedge funds to fend for themselves. 

Update on Saturday, October 25, 2008 at 06:00PM by Skeptic

There's a rush to get the new federal bailout money, and they want the same very favorable terms that Treasury "forced" on the first beneficiaries.  And, yes, the initial recipients are going to hoard the money or use it to acquire smaller banks and not increase lending although Treasury intends to "urge" them to increase lending.