The government doled out $125b of equity injection to 9 banks yesterday. It is a dramatic change from the original TARP proposal (to pay a premium price for toxic assets). I have advocated for weeks an equity injection (along with other measures).

However, there are serious problems with the government’s implementation.

1. There is no guarantee that this money gets into the credit system. Indeed, some institutions, like Morgan Stanley, might use this to reduce their risk rather than increase their lending.

2. What about the other 8,000 financial institutions? If they are healthy, they will not apply for the government equity. If they apply, people will assume they are troubled. There is a stigma effect. Hence, the government money will go to the most troubled institutions — exactly the institutions that are unlikely to use these funds to increase loans. So the multiplier effect (capital injection leads to loan creation that is a multiple of the initial injection) is muted when capital goes to troubled institutions – or borderline institutions that just want to reduce their risk.

3. Government only gets 15% of any equity appreciation. If they bought common shares, they would get 100% of any gain. It is a deal of dubious value to the American taxpayer. It smells like ‘bailout’ rather than ‘investment’.

4. What happened to the “TA” in the TARP? We need a comprehensive program that addresses equity injection, troubled assets, as well as the individual loans themselves.

Here is a different approach to equity injection:

Mandatory investment in financial institutions (which solves the stigma problem). The amount of equity should be small and passive. No investment in financial firms below the margin – relegate them to a new RTC like entity. Five to seven year term holding period and then government liquidates their stake. The fund gets all the upside for their investment (not just 15%). Essentially, the government is running a giant hedge fund with two differences. First, the principals of the fund have ‘inside’ information from FDIC on the health of the banks they are investing in (and, hence, can avoid bad bets). Second, we know that the government will take other actions, fiscal and/or monetary to make sure the investment pays off.

Sounds like an attractive fund to invest in? It surely has a positive expected return. Indeed, the upfront cost to the government would be greatly reduced if they opened this fund up to private investors.