The Paulson Plan - why not equity?

Along with a growing multitude, Sebastian Mallaby, in an article in the Washington Post has mooted the idea of forcing banks to raise capital directly by issuing new equity. Aside from a need for political expediency, I don't think this one will fly.

It looks like Mr. Paulson has taken the view that the problem is not that the banks are under-capitalised. The problem his plan is trying to resolve is that the banks have assets on their books for which there is no market and hence no reliable market price. This bailout is not, or at least certainly shouldn't be, about getting more capital into the banking sector. It is about removing that uncertainty from bank balance sheets.

Simply providing more capital to the banks won't remove that uncertainty, however it is done. The assets of unknown price stay on their books. What is needed, as the Treasury has diagnosed it, is to quarantine the assets. I think this is probably right.

Moreover, it is not as if banks haven't tried to raise new equity capital. Certainly they have in the UK with a number of rights issue. Largely these have not been all that successful. There just isn't an appetite for banking equity at the moment.

That would leave the taxpayer to buy the new shares. And, indirectly then, those "toxic" securities are still on the public balance sheet because they are owned by banks in whom the Treasury now has an equity stake. It's hard to see the benefit apart from some dilution of the risk. But the cost of that is that those mortgage-backed securities are still creating large uncertainties about banks' balance sheets.