Using the Price of Magic to Estimate the Cost of Capital

On Friday, I wrote about the delightful capital arbitrage of DTA-linked notes, in which banks are looking to "get 'capital' by securitizing tax deductions from past losses."1As I put it then, one way to get capital is to sell stock, which is expensive, so the banks are looking to rely on magic instead, because magic tends to be cheaper.

That was a glib but controversial statement. Broadly speaking banks can raise debt cheaply, and bankers believe that their equity is expensive. There is a notion that banks have a cost of equity of 10 percent, though that is a pretty vague notion; in any case, belief that equity capital is more expensive than debt is widespread. Some people disagree, though; Anat Admati is particularly adamant that bank capital is cheaper than the bankers let on.2