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Debt Overhang and Bank Bailouts

Linus Wilson

University of Louisiana at Lafayette - College of Business Administration

September 12, 2009

When a bank is deemed "too-big-to-fail" by regulators, it may be tempted to buy risky assets. This paper analyzes bank bailouts involving the purchases of toxic assets, preferred stock, and common stock when the government wants to encourage efficient lending. It finds that preferred stock recapitalizations are the least efficient in correcting debt overhang problems from both an ex post and ex ante perspective. In contrast, efficient lending and voluntary participation can be best achieved without subsidy by purchasing either toxic assets or common stock. Nevertheless, troubled banks must be subsidized if they will voluntarily participate in any recapitalization.

Number of Pages in PDF File: 42

Keywords: bailout, banking, debt overhang, common stock, Capital Assistance Program, Capital Purchase Program, Emergency Economic Stabilization Act, lending, preferred stock, Public-Private Investment Partnership, PPIP, TARP, too big to fail, toxic assets

JEL Classification: G21, G28, G38

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Date posted: February 2, 2009 ; Last revised: September 17, 2009

Suggested Citation

Wilson, Linus, Debt Overhang and Bank Bailouts (September 12, 2009). Available at SSRN: https://ssrn.com/abstract=1336288 or http://dx.doi.org/10.2139/ssrn.1336288

Contact Information

Linus Wilson (Contact Author)
University of Louisiana at Lafayette - College of Business Administration ( email )
Department of Economics & Finance
214 Hebrard Blvd., Room 326
Lafayette, LA 70504-0200
United States
(337) 482-6209 (Phone)
(337) 482-6675 (Fax)
HOME PAGE: http://www.linuswilson.com
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