FED Bailout

Buying the existing debt allows banks to clear their B/S of toxic assets, which promotes confidence amongst banks and consumers so that banks can begin to lend again. The government should set up a $700B distressed debt fund that purchases these toxic assets. The problem is that no one knows what these assets are worth and every asset is completely different. Without the appropriate transparency valuation is impossible and extremely time consuming. Time is against us as confidence continues to deteriorate.

Wouldnt an equity infusion simply be pumping more liquidity into the market, which wouldnt completely solve the problem?

restoring confidence and providing transparency is essential if we're going to emerge from the credit crisis. the media 100% sensationalized - i haven't seen one news program actually explain the mechanics of the bailout.

an equity infusion wouldn't solve the questions regarding the valuation of the assets.

No the equity infusion wouldn't solve the valuation question, but what it would do is shield banks from being completely wiping out their equity base with potential write downs.

say you are MS and have 50BN of toxic stuff on or off your balance sheet. You don't like losses on it because that reduces your retained earnings. The fed props up your equity by buying a huge stake in your company. Yes, they may own a huge chunk of you for a while, but now if you losses, the Fed will absorb them.

So valuation of assets is still market determined. That's what a lot of republicans are complaining about now -- the Fed is doing a reverse auction in this debt bailout where the banks will set the bids and create inflated valuations. This will prevent losses for the banks.

In addition, the equity you acquire in the company will become valuable over time. As you slowly unload assets the value of the stock you buy will increase and can be sold at market rate to the public or back to the company.

While the banks will offer the Fed a purchase price for their toxic securities, the Fed only purchases the cheapest (i.e. if they do an auction for $50b of these securities, they will start at the bottom of the price spectrum and continue to purchase until they've spent the allocated amount).

Slowly unloading these assets isn't an option since action is required immediately to unfreeze the credit markets. The LIBOR-OIS spread reached 200 basis points a few days ago; comparatively, I believe it was at 8 basis points last July. Case and point, banks are hording their cash and even curbing overnight loans. An equity infusion would certainly provide a "crutch". It would not, however, do anything to reduce the uncertainty regarding valuation of these securities, which is at the heart of the problem.

we should purchase some existing debt off of bank balance sheets because
- its the quickest and surest way give a liquidity boost to banks whose credit lending is stringent because of provisions or valuations related to mortgage assets either on their own books or the books of competitors.

but we also need the equity infusion because
- it increases the upside potential for the government as a direct investor if/when the mortgages market recovers and banks benefit in other areas sooner vs the governments more long term mortgage returns
- decreases the pressure of having to exactly pinpoint the clearing level of asset pricing by recapitalizing banks that may/have to write down mortgage assets to the governments clearing level
- it reduces moral hazard by penalizing the investors in entities that need government assistance (if we prioritize it above other forms of equity)