Banks Are Running Out of Options

Updated from Thursday, Oct. 9

As Treasury Secretary Henry Paulson formulates a plan that could essentially nationalize a large swath of the U.S. banking industry, shareholders have become inevitably spooked.

But some experts say there are few other palatable options to shore up the financial sector.

The government already has the right to receive warrants for equity stakes in companies that participate in its plan to purchase $700 billion worth of illiquid mortgage holdings. Those assets are clogging banks' balance sheets and sapping investor confidence, and they have caused the demise, rescue or takeover of several firms in the past several weeks.

Paulson, who first opposed the inclusion of such a measure in the bailout bill, said on Wednesday that the government would "use all of the tools we've been given, including strengthening the capitalization of financial institutions."

Reports suggest that he is now deciding how the government's equity injections would be structured, and White House spokeswoman Dana Perino said on Thursday that Paulson is "actively considering" such a plan.

The Bank of England announced a similar plan this week, pledging billions of dollars in capital in exchange for preferred stock in banks. The obvious losers in such a strategy will be existing shareholders, whose stakes will be significantly diluted.

The stock performance of Freddie Mac (FRE Quote - Cramer on FRE - Stock Picks), Fannie Mae (FNM Quote - Cramer on FNM - Stock Picks) and AIG(AIG Quote - Cramer on AIG - Stock Picks) provide ample evidence. Share prices of those companies dropped to a mere fraction of their former worth on the first trading day after the U.S. announced plans to take over those firms, and had fallen precipitously in the previous days on fears that such a bailout would occur.

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