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If a bank faces potential insolvency, it will be tempted to reject good loans and accept bad loans to shift risk onto its creditors. The authors analyze effectiveness of buying up toxic mortgages in troubled banks, buying preferred stock, and buying common stock. If bailouts for banks that are deemed "Too-big-to-fail" involve buying assets at above fair market values, then these banks are encouraged ex ante to gamble on bad assets. Buying up common (preferred) stock is always the most (least) ex ante- and ex post-efficient type of capital infusion, whether or not the bank volunteers for the recapitalization.
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