In the sheer panic and haste to do something, the Paulson plan (the $700B bail-out plan for the financial sector) is rather ill conceived according to a host of economist. It’s much more efficient to inject capital directly into the banking system through buying ownership stakes than it is indirectly by buying dodgy illiquid assets. Someone in the Treasury department seems to have woken up to that fact. That’s good!

George Soros was only one who argued this:

• “Funds injected at the equity level are more high-powered than funds used at the balance sheet level by a minimal factor of 12,” Soros writes in the Financial Times

Initially, there wasn’t even a rationale behind the Paulson plan. According to Paul Krugman, but he figured out that that logic must be “slapping markets back to their senses”, or, in other words, helping them with “price discovery.”

The markets for the exotic products backing up mortgages had gotten in such a funk that they couldn’t figure out the right prices for these products anymore, instead they priced them too low (or even zero) as there were no buyers and the markets dried up.

Since financial institutions have to value these instruments on their books at market value, their asset base shrunk, forcing them to sell, which depressed values even more for other institutions. The Paulson plan’s logic is to break that vicious cycle.

But, even according to Krugman and others, it’s more efficient to directly inject capital into financial institutions and it has happened in every major bank bailout in history. Apparently, that’s what is being considered now:

White House considers ownership stakes in banks
Thursday October 9, 6:09 am ET
By Martin Crutsinger, AP Economics Writer
White House considers taking ownership stakes in private banks to deal with credit crisis

• WASHINGTON (AP) — The Bush administration is considering taking ownership stakes in certain U.S. banks as an option for dealing with a severe global credit crisis.
• An administration official, who spoke on condition of anonymity because no decision has been made, said the $700 billion rescue package passed by Congress last week allows the Treasury Department to inject fresh capital into financial institutions and get ownership shares in return.
• This official said all the new powers granted in the legislation were being considered as the administration seeks to deal with a serious credit crisis that has caused the biggest upheavals on Wall Street in seven decades and continues to roil global markets.
• Supporters of this approach, such as Sen. Charles Schumer, D-N.Y., argue that injecting fresh capital into U.S. banks who want to participate in the program would be an effective way to bolster banks’ balance sheets and get them to resume lending. Taxpayers would benefit because the government would receive an equity stake in the bank in return for providing the capital.
• “This idea would, at a minimum, complement the administration’s planned approach of buying up troubled assets and may prove to be the most promising tool of all in Secretary Paulson’s kit,” Schumer said in a statement.
• A decision to inject capital directly into financial institutions in return for ownership stakes would be similar to a plan announced Wednesday by Britain.
• Treasury Secretary Henry Paulson told reporters that Treasury was moving quickly to implement the $700 billion rescue effort and he specifically mentioned reviewing ways to bolster the capital of banks.
• “We will use all the tools we’ve been given to maximum effectiveness, including strengthening the capitalization of financial institutions of every size,” Paulson said at a Wednesday news conference.
• Asked whether he would try something like the British plan, Paulson said: “We have a broad range of authorities and tools. … We’ve emphasized the purchase of liquid assets, but we have a broad range of authorities. And I’m confident we have the authorities we need to work with going forward.”
• The administration so far has stressed its major goal is to purchase bad loans from financial institutions.
• Paulson said that while the financial market turmoil has hurt the economy, the administration is moving quickly to begin the largest financial system rescue effort in history.
• Even with the program to buy bad assets from financial institutions, he said, some banks will fail. He also called for patience, saying “the turmoil will not end quickly and significant challenges remain ahead.”
• In an attempt to help stop the financial crisis from causing a global economic recession, the Federal Reserve and other central banks cut interest rates in a rare coordinated move Wednesday.
• Paulson called the coordinated rate cuts “a welcome sign that central banks around the world are prepared to take the necessary steps to support the global economy during this difficult time.”
• Paulson on Monday selected Neel Kashkari, 35, an assistant Treasury secretary, to be the interim head of the new program. In his remarks Wednesday, Paulson said the administration would move quickly to nominate someone to fill the job permanently.
• Paulson said he was consulting with President Bush, congressional leaders and presidential candidates Barack Obama and John McCain before choosing someone to fill the job permanently. The post requires Senate confirmation, something Paulson predicted could occur in November.
• The administration has been rushing to implement the program, which cleared Congress last Friday. Paulson said it would be several weeks before the program makes its first purchases of troubled assets.
• “U.S. and global financial markets continue to be severely strained,” Paulson said at the briefing called to preview the upcoming weekend meetings of finance officials of the Group of Seven major industrial countries, the 185-nation International Monetary Fund and the World Bank. The global credit crisis was expected to be the major agenda item at those talks.