This is how Tarp ought to work. The Treasury secretary should begin by asking the banking supervisors to produce an estimate for each bank, how much additional capital they would need to meet the statutory requirement of 8 per cent. The supervisors are familiar with the banks and are aggressively examining and gathering information. They would be able to come up with an estimate in short order provided they are given clear instructions on what assumptions to use. The estimates would be reasonably reliable for the smaller, simpler institutions, but the likes of Citibank and Goldman Sachs would require some guesswork.
Managements of solvent banks would then have the option of raising additional capital themselves or turning to Tarp, which would state the terms on which it is willing to underwrite a new issue of convertible preferred shares. (Convertibles are better than warrants because the banks should not need additional capital infusions later.) The preferred shares would carry a low coupon, say 5 per cent, so as not to impair banks' profitability. The new issues would dilute existing shareholders but they would be given preferential rights to subscribe on the same terms as Tarp and if they were willing and able to put up additional capital they would not be diluted. The rights would be transferable and if the terms were set right, other investors would take them up.
Using this approach, $700bn should be more than sufficient to recapitalise the entire banking system and funds would be available to buy and hold to maturity mortgage related securities. Since insolvent banks would not be eligible for recapitalisation, the Federal Deposit Insurance Corporation would certainly require topping up.