If Warren Buffett can do that why can’t we X 100 ?

Robert Waldmann’s Pony Plan.

This plan is modeled on Buffett’s deal with Goldman Sachs. It is also based on arguments by Doug Elmendorf and Luigi Zingales. I may show how good ideas from smart people can be sliced and diced to make toxic foolishness.

One reason the deal had an impact is that it was a signal that Buffett thinks that Goldman Sachs was, at most, $ 5 billion in new capital short of sound. The remaining banks in trouble are less sound (I assume Buffett knows what he is doing) and those who participate in my plan will be the least sound banks.

That said, I think that a lot can be accomplished by issuing new preferred shares to the Treasury.

I’d say the deal is
1) banks can issue preferred shares to the Treasury worth up to 1% of their total assets.
2) These shares pay a 10% annual dividend.
3) the Treasury gets an equal number of warrants to buy common stock at its price as of when the bill passes.
3) At any time t, the bank can buy back any or all of the preferred shares for the original price plus interest equal to 2% per year plus the linearly interpolated average of the treasury bills issued when this bill passes and maturing just before and just after t
4) While any of the preferred shares are outstanding, for each employee, consultant or person who provides any service for pay, the bank must transfer to the treasury the greater of $0 and half of the difference between that person’s total compensation and $ 400,000.

Why would this work? The new equity would improve banks’ capital ratios. Given the law as it is and should be, capital is assets minus debts and equity doesn’t enter.
The risks to the Treasury are 1) that the bank will fail and 2) that it will never pay dividends so the preferred shares are worthless.

Probably, few banks would pay the huge dividend, therefore they would not be allowed to pay dividends on common stock. The 10% dividend is a price the bank has to pay to the treasury for the privilege of paying dividends on common stock. Even the most impatient shareholder must understand that it would be better to buy back the preferred stock first. Thus, while wholly voluntary and using a standard instrument (preferred stock) the plan would discourage banks from paying dividends causing them to build up capital.

Clause 4 is not populist vengeance. My guess is that even investment bankers trust each other enough to keep track of unofficially assigned bonuses, so that when they are finally free of the preferred shares, they will get bonuses based on performance during the period clause 4 applies. This has the effect of making officers of banks loan money to the bank when the bank really needs money. It also penalizes them for not repurchasing the preferred shares. In particular, informal promises to pay are attractive to corporate predators who profit by violating implicit contracts. The combination of no dividends on common shares and implicit debts to managers would make the banks very attractive takeover targets. This would create an incentive to buy back the preferred shares.

The 2% extra interest which must be paid no matter who is secretary of the treasury is partly to cover the losses from banks that fail and partly to get all that the market will bear for the Treasury.

The phrase Pony Plan TM belongs to Atrios. Illustration after the jump.