Corporate & Securities Law

Verret on the Self-Defeating Bailout

My colleague JW Verret has an interesting take on the bank bailout at Forbes.com:

This deal was intended to bolster public confidence in banks, while at the same time minimizing the cost of the bailout when Treasury sells its shares once markets pick up. The form of equity Treasury has taken, and plans to take in the second round of the bailout, threatens to destroy both goals.  This is because governments have two unique qualities: immunity from insider trading laws and a political interest in using their shareholder power to pander to special interests.

A healthy share price makes for a healthy bank. But healthy share prices require healthy profits. When governments become powerful shareholders in companies, the profit motive is inevitably watered down.

After European governments privatized government-run industries in the 1980s they maintained powerful equity positions in the privatized firms. Those companies were twice as likely to need to subsequently obtain subsidies and bailouts at the public trough.

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Another important consequence of the bailout is that Treasury’s access as a regulator to inside information about banks makes it the ultimate inside trader of stocks in financial institutions. Luckily for the federal government, it has sovereign immunity from insider trading laws.

The market will significantly discount the value of banks in which Treasury is a shareholder. Since the dominant player in that market has the opportunity to engage in insider trading, it makes little economic sense for other investors to buy bank shares. Why would anyone want to play the game when they know the game is rigged?

To protect against insider trading liability, corporate executives file “10b-5 plans” that detail future share sales. Treasury should be bound to the same kind of plan to assure investors that it will not use inside information to trade its shares.

Full post as published by Truth on the Market on March 07, 2009 (boomark / email).