Did Paulson Get the Incentives Right in the Bank Bailout?

The short answer is -- no.

1) The Banks get below cost capital grants.  Loans would cost 11 to 12 percent.  The government gives them cash at 5 percent for five years and 10 percent thereafter with optional repayment; it is senior preferred stock.  Large banks cumulate foregone dividends on the preferred; small banks do not.  Existing shareholders still get dividends at past levels (no increases) and the government cannot vote any of its stock. Why ever pay it back?  Paulson can point to two incentives to repay. 1) At the market warrants on 15 percent of the value of the initial preferred stock purchase. Note that the market is on the grant date (with a 20 day average), which includes the increased value added by the government's own program.  The strongest incentive is to recapitalize in one year so as to half the warrants.  If this is not possible, the warrant incentive to repay flattens out considerably.  A firm just absorbs the dilution on common dividends; the government cannot vote.   2) Executive compensation control, which is easy to get around, by the way. 3) Pressure to forgive mortgage payments.

2)  Banks get $2.25 trillion, yes trillion, in free or below cost loan guarantees.  A government guarantee on new senior secured debt is cheap; a unlimited guarantee on non-interest bearing deposits is free.   Why not up the guarantee on interest bearing accounts, presently at 250,000?  Money from other world banks will flow into the US to take advantage of the federal guarantee which is stronger than other government's guarantees.  We are worried about sucking up the world's cash in our banks.

3)  Lehman, J.P. Morgan and AIG look like AAA suckers.  They paid dearly for their capital infusions.  Greenberg, the ex-CEO of AIG and a major shareholder, is, sensibly, asking the government to renegotiate the AIG bailout package.  The lesson for future crises?  Stall, stall, stall.

4)  The world's banks look like AAA suckers.  In the UK, banks give management power to the government (voting rights, seats on the board) and can no longer pay dividends on common until the government grant has been paid back. 

Did you expect Paulson to create the proper incentives?  What should American banks do?  Take the money and run; hold it as long as dividend rates on preferred stock in the market are over the 5 and then 10 percent rates (five years at minimum and perhaps considerably longer). Issue as much senior short term guaranteed debt as they can get away with and continue to pay executives whatever they want (with promises that comport with the new Treasury regs).  Use the new debt to lever up on some new sucker play -- tax subsidized biofuel companies??