We've come to this pass in part because the Obama Administration is afraid to ask Congress for the money for a meaningful bank recapitalization. And it may need that money now in part because Mr. Paulson's Treasury insisted on buying preferred stock in all the big banks instead of looking at each case on its merits. That decision last fall squandered TARP money on banks that probably didn't need it and left the Administration short of funds for banks that really do.
The sounder strategy -- and the one we've recommended for two years -- is to address systemic financial problems the old-fashioned way: bank by bank, through the Federal Deposit Insurance Corp. and a resolution agency with the capacity to hold troubled assets and work them off over time. If the stress tests reveal that some of our largest institutions are insolvent or nearly so, it's then time to seize the bank, sell off assets and recapitalize the remainder. (Meanwhile, the healthier institutions would get a vote of confidence and could attract new private capital.)
Bondholders would take a haircut and shareholders may well be wiped out. But converting preferred shares to equity does nothing to help bondholders in the long run anyway. And putting the taxpayer first in line for any losses alongside equity holders offers shareholders little other than an immediate dilution of their ownership stake. Treasury's equity conversion proposal increases the political risks for banks while imposing no discipline on shareholders, bondholders or management at failed or failing institutions.