by Calculated Risk on 9/24/2008 01:02:00 PM

I listened to Chairman Bernanke's testimony this morning. It is clear the goal is to recapitalize the banks, and Dr. Bernanke implied this would happen either by paying more than current book value (with the banks taking write-ups) or by building confidence in private investors after the toxic securities are bought by the taxpayers.

Bernanke went on to say that private investors might not be interested in investing if there were contingent shares outstanding - because they would be afraid of dilution.

From Bloomberg: Paulson, Bernanke Put Bank Aid Ahead of Best Deal

Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben S. Bernanke have signaled that their priority is shoring up the nation's banks even if it means they don't get taxpayers the cheapest prices for the devalued assets the government buys.

``I am not advocating that the government intentionally overpay,'' Bernanke told the Joint Economic Committee today, in response to a question from U.S. Rep. Jim Saxton, a New Jersey Republican.
...
Senate Banking Committee Chairman Christopher Dodd has proposed that the Treasury potentially receive equity stakes in some companies that sell assets to the government. The stakes would ``vest'' in an amount equal to the 125 percent of the dollar value of the loss realized by the Treasury on the sale of the assets.

That type of ``loss participation'' proposal would endanger companies' ability to raise private capital afterwards, Jeffrey Rosenberg, head of credit strategy research at Bank of America Corp. in New York, wrote in a report yesterday.

And if the program was changed to an RFC type recapitalization (as opposed to buying toxic assets), then most lenders wouldn't participate until they were at death's door.

What a mess.

And a final point, many people are saying the government can only lose a portion of the $700 billion because there will be offsetting assets. This is true in the Fannie and Freddie conservatorship (the mortgage assets mostly offset the debt of Fannie and Freddie), but it is not true here. Although Paulson and Bernanke are talking about hold-to-maturity prices, they are also talking about both buying and selling securities. A little math will show that if you take a loss (say 30%) on each transaction, it doesn't take many transaction to lose most of the entire $700 billion.