It is only fair for taxpayers to expect to benefit if hundreds of billions of dollars of their money is used to purchase poor quality debt from financial services firms. However, taxpayer profit sharing must be carefully structured to avoid endangering the economy’s recovery by discouraging firm’s to participate in the plan. Further, it must not result in the government owning parts of a company or trying to meddle in its management.

How to structure the provision:

Rather than giving either the government directly or the new entity that purchase financial assets stock in companies that seek to sell assets as part of the transaction, the legislation should require the company to issue warrants that would allow the bearer to purchase a set amount of common stock at some point in the future at a price that is at least 20 percent higher than company’s current stock price. The warrant would also have a set expiration date, and could not be exercised by the government or any government entity.

After the economy recovers and the financial situation is stabilized, the new Office of Financial Stability (OFS) could sell those warrants on the open market, thereby empowering the buyer to purchase company stock at the price and in the amount specified in the warrant. The taxpayers would benefit when the warrant is sold, the company would have had the value of the asset buyback, and purchaser of the warrant would be able to buy the stock. Obviously, if a company’s stock does not increase in price before the date that the warrant expires, the warrant becomes worthless and cannot be sold.

The amount of stock that the warrants would cover should be based on the proportion of assets that the company sells in the aggregate to the OFS.

A past example:

As part of the 1979 Chrysler bailout, the US government received warrants good until 1990 allowing it to purchase 14.4 million shares of common stock at a price of $13 per share. In the end, the warrants were exercised in August 1983, thus bringing the taxpayers a gain of about $230 million in addition to $32 million that they collected in fees. Heritage opposed the Chrysler bailout in principle. We did not think it was necessary at the time. Today’s credit freeze situation is different.

UPDATE: Some very respected conservatives worry that requiring Treasury to take warrants could defeat the effectiveness of the bill since firms are required to count them as liabilities on their books. This is a fair point, but the value of warrants with future effective dates are heavily discounted. Therefore, they will not materially affect the over all effectiveness of the plan.