Give the Banks What They Need: Capital!

This post first appeared on Minyanville.

Battered American banks could be nearing a turning point.

As the Treasury Department scrambles to implement the newly minted $700 billion Emergency Economic Stabilization Act of 2008 -- otherwise known as the “bailout to (hopefully) end all bailouts” -- Wall Street and Washington participants alike are gaining mindshare that direct capital injections may be the speediest way to right the country's sinking financial ship.

Yesterday, Britain announced it would invest up to $87 billion in its four largest banks, including Royal Bank of Scotland, HSBC (HBC) and Barclays (BCS). The move, coupled with plans to back almost $500 billion in bank debt, is aimed at giving British banks the confidence they need to begin lending again.

Similarly, here in the U.S. massive mortgage and credit-related writedowns, mounting losses on consumer loans and chaos in short-term money markets are forcing banks to hoard cash. Until that money can flow freely into the financial system, allowing businesses and consumers to resume their spending ways, the economy will continue to nosedive.

Over the past two days, Minyanville’s resident banking expert Minyan Peter has laid out some of the reasons taxpayers should hope their billions are used to this end, rather than sopping up illiquid assets.

Since the onset of the credit crisis, financial institutions worldwide have written off nearly $600 billion, while raising just $440 billion in new capital, according to Bloomberg. In recent months, jittery investors have shied away from pouring new money into banks. Just yesterday, the banking sector was rattled as Bank of America (BAC) was forced to lower the offering price of its $10 billion capital raise.

Worried their investments may plummet in value like early forays of sovereign wealth funds into the likes of Morgan Stanley (MS), Merrill Lynch (MER) and Citigroup (C), would-be investors have turned into patient observers.

By purchasing common equity, Minyan Peter argues, the government could not only give banks much needed cash to shore up their balance sheets, but would also provide a base upon which private money could confidently return to the market.

Common shareholders bear the brunt of losses when a company flounders - just ask owners of Bear Stearns, Countrywide, Lehman Brothers or AIG (AIG). By taking this first loss position, Treasury’s investment would provide a buffer that would make future private investments more secure. Investors could more confidently move money out of the safety of Treasuries and into the banking sector, where it is so sorely needed.

To be sure, taxpayers would be mightily exposed and probably lose a substantial chunk of their investment. While politically hard to swallow, taking a manageable loss now is much preferable to finding ourselves with trillion dollar bailout part deux this time next year.

Critics worry banks will be reluctant to opt into such a plan, as issuing common equity would dilute existing shareholders. True, but most shareholders would agree that dilution is vastly preferable to outright liquidation.