How will a capitalization plan actually work?

I’m all for bank capitalization but the problem is this: the Fed has been lending hundreds of billions to banks for many moons.  Right now the banks are just sitting on the money, for the most part. 

To be sure, Treasury equity is not the same as debt to the Fed, but are they so different?  Keep in mind the Fed has been a softie to A.I.G. ($30 billion more), so the Fed is hardly a loan shark and in some ways the Fed’s I-can’t-just-stop-rolling-it-over-when-I-want contribution is a bit like preferred equity.

To put it another way, will partial government ownership so much change bank incentives for the better?

Which is it?

1. Treasury capitalization will matter to the extent that Treasury equity has some different properties than from-the-Fed debt, but this isn’t nearly as much of an effect as any published sum for a Treasury capital inflow would indicate.

2. Treasury equity will work because of some legal or regulatory difference between equity and debt which we are otherwise unwilling to abolish.

3. Treasury equity will work because it is a hidden giveaway to bad banks (by the way, this is arguably what happened in Sweden).  But of course we could do the giveaway more directly if not for bad PR.

Inquiring minds wish to know.

Three other points:

4. Capitalization might have a bigger marginal oomph in Europe than here, because the ECB hasn’t been going crazy lending out reserves as the Fed has.

5. If the key is to get banks up and running again, we want bank CEO contracts with lots of bonus compensation on the profit upside and those contracts are more important the "worse" is the bank.  Ouch.

6. If such a plan will raise the value of lots of banks, by a lot, none of the shareholders will wish to sell early at low prices, a’la Grossman and Hart 1980, and the Treasury will be back in a bind.

That is what Alex and I talked about over dinner.  I conclude that the crisis will not end anytime soon.