Deal Journal: What the heck is going on out there? The Citigroup bailout isn’t a good sign of confidence in the overall financial system, is it?
Charles Calomiris: The key thing we’ve learned during the downward spiral of confidence is that you have to deal with the problem in the mortgage market directly. There are probably 18 million subprime and Alt-A mortgages out of 57 million total. Probably half will end up in foreclosure.

In the middle of a financial crisis, we’re using half measures designed in an inappropriate way, and we don’t accompany them with other measures. This has just been a completely mismanaged policy response.


DJ: So what’s the matter with some of Paulson’s latest ideas?
CC: Warrants are a bad idea. They dilute common stock holders, and make it harder to design common equity. It’s been a design flaw all along. It’s all a part of thinking of these things in terms of deals. They’ve got Warren Buffett envy.

But in terms of ways that truly recapitalize a bank, they’re truly idiotic.

If you attach warrants that are dilutive, it’s harder to issue common stock. If you want to make money, go buy stock. If you want to increase the net worth of a bank, make that coupon as low as possible and require matching common stock issues. If you learn you can’t do it [the common stock match] then have to decide whether to do a common stock injection, an assisted merger, or shut the bank down.

DJ: Why isn’t anyone listening to these ideas?
CC: The point is that they have made huge errors in the design of their assistance plan and they were forecastable errors.

For instance, Paulson doesn’t want there to be a stigma [around capital injections.] Does he really believe that by getting J.P. Morgan to participate, he creates the perception that JPM and Citi are the same?

Does he really believe that injecting preferred stock into banks is socialism but buying assets at above market price isn’t? Does he really believe that?

There actually is a stock of knowledge about this. The scandal is that when Congress has been considering this, not one independent economist has been allowed to testify. Do you know why they weren’t? Paulson and Bernanke didn’t want anyone causing problems.

DJ: Wait, that sounds like a conspiracy.
CC: Democrats didn’t want anyone [economists] testifying because it was before an election and no one was willing to stand before that bulldozer known as Paulson. No one wanted to make tough political decision before the election. They didn’t empower any experts to come in and testify. Why is that? They were playing politics, too. That’s what we’re dealing with–a complete leadership failure in Congress and the administration.

Don’t underestimate the role of politics in the decision not to fix things.

When does this stop????