No, Wait! You Got It Backwards!

AKA, Convertible Preferred Stock for Beginners.

There is nothing inherently wrong with convertible preferred stock. In Silicon Valley, for example, venture capitalists almost always invest by buying convertible preferred. The idea is that in the case of a bad outcome, the VCs are protected, because their shares have priority over the common shares held by the founders and employees. Say the VCs put in $10 million for 1 million shares, and the founders and employees also have 1 million shares, so the company immediately after the investment is worth $20 million. If the company liquidates for $15 million, the preferred shares have a “preference,” which means they get their $10 million back (often with a mandatory cumuluative dividend as well) first, and the common shareholders take the loss. However, in a good outcome, the VCs can exchange their preferred shares one-for-one for common. So if the company gets sold for $100 million, the VCs convert, and they now own 50% of the common stock, so they get $50 million.

When I heard that the government was going to give future capital as convertible preferred stock, and perhaps change some of the previous capital injections to convertible preferred, I thought this was a good thing. It would give the taxpayer more upside potential, and it would also give the government the option to take over the banks simply by converting its preferred stock to common whenever it wanted.

But the key in the Silicon Valley example is that the VCs have the option to convert or not. The Treasury Department’s new Capital Assistance Program has this precisely backwards.

Under the new Capital Assistance Program (CAP), the government will invest in banks by buying preferred shares with a 9% dividend. This is like the old Capital Purchase Program (used last fall for the first round of recapitalizations), but with one huge twist. Now the bank, AT ITS OPTION, can choose to convert the preferred shares into common, at 90% of the average closing share price during the 20 days ending on February 9 (the day before the new Financial Stability Plan was “announced”).

An example would probably help here. Let’s say that Bank of America (BAC) needs another $25 billion in capital. The government will give BAC $25 billion in cash, which BAC has to pay back in 7 years (that’s the mandatory conversion date). In the meantime, BAC has to pay 9% interest, or $2.25 billion, per year. But, at any time, BAC can convert any amount of that to common shares, at $5.49 per share. (The average closing price over the 20 days was $6.10.) If it converted $5 billion into common, the government would get about 910 million (5 billion divided by 5.49) common shares, but now BAC only owes the government $20 billion and is paying 9% interest on only $20 billion.

In short, BAC has just sold the government 910 million shares for $5.49 each.

This is called a put option. At any time, BAC can sell (“put”) shares to the government for $5.49, but it never has to. (The convertible shares the Silicon Valley VCs get are like call options; at any time, they can buy common shares by trading in preferred shares, but they never have to.) Having an option is always good.

What will BAC do with this option? If its stock price is above $5.49, it can either do nothing, or it can issue new common shares and sell them to private investors, say at $8. Then it can use that $8 to buy back preferred shares from the government, or just hold onto it. If its stock price falls below $5.49, things get interesting. Then BAC can buy up its shares on the market for, say, $3, and then immediately sell them to the government for $5.49. It won’t get $5.49 in new cash, but it will reduce its debt to the government – because preferred shares that have to be bought back and pay interest are basically debt – by $5.49, which is almost as good.

(This would have the side effect of supporting BAC’s stock price, because it means there is a buyer (BAC) who is theoretically always willing to pay $5.48 for the stock. Ricardo Caballero must be smiling)

In practice, it’s not quite this simple, because the bank will require Treasury’s permission to buy back common shares from other investors. But even if BAC doesn’t buy back any shares, it still has the option – whenever its stock price is below $5.49 – of reducing its debt to the government by $5.49 simply by giving the government a share worth less than $5.49.

What’s wrong with this? Well, nothing, if your goal is to give banks money. What you’ve just done is stick the government with the downside risk – we could get paid back in worthless stock – while the bank shareholders get all the upside potential. You’ve done this by giving the bank, for free, an option that has value. Back of the envelope, Peter thinks this option is worth about 65 cents per dollar of money invested. (It’s worth so much because bank stocks are so volatile these days.) Put another way, for every $10 billion of capital we invest this way, we are giving away another $6.5 billion. I think it’s probably a little less, because the option is not as flexible as the holder would like it to be, but you get the point.

As I’ve said many times before, if you think the banks need money, and you want to give it to them (instead of, say, nationalizing them), just give it to them already. Don’t come up with these ridiculously fancy schemes to hide it. Yesterday Krugman gave Simon and me credit for writing this sentence:

This is another sign of the serious brainpower that has been expended on finding ways to avoid or minimise government ownership of banks, and to avoid the slightest possibility of offending shareholders – shareholders whose shares have positive value primarily because of the expectation of a further government bail-out.

But to tell you the truth, at the time we wrote that I didn’t realize just how much brainpower went into this one.

There are some other worrying things in the term sheet I’ll just touch on here:

  • Any qualifying financial institution can get anywhere from 1 to 2% of the value of its assets under this program, simply by asking – even if it doesn’t need it. I guess if you’re going to be giving gifts (free put options) to the banks that need to be saved, you need to be fair and give the same gifts to banks that don’t need to be saved. Banks will need regulatory permission to get more than 2% – a clear sign that getting money under this program is a good thing for banks.
  • On top of that 2%, any qualifying financial institution can get additional money under this program in order to retire the preferred stock it sold last fall under the Capital Purchase Program. This means they can take back non-convertible preferred stock and give the government convertible preferred stock instead, with no cash changing hands.The dividend rate on the new stuff is higher (9% vs. 5%), so a bank wouldn’t necessarily do this. But if its stock price is lower than its conversion price (the average price on the 20 days ending on February 9), then it should do the swap, and then immediately convert the preferred into common (so the dividend goes away). That way, instead of owing the government, say, $10 billion and paying interest on it, it can give the government $5 billion worth of common stock instead. (For those asking the obvious question: Citigroup’s conversion price is $3.46. Yesterday it closed at $2.52. You might call this one the “Citigroup clause,” not to be confused with Santa Claus.)
  • The convertible preferred stock will have no voting rights. This is hardly surprising, given that the whole point of the exercise is to avoid government control. But it’s by no means necessary. For example, VC firms always get voting rights for their convertible preferred shares.

There are some very clever people in Treasury these days.

Update: Oh, I forgot the most important point. This still does nothing for the asset side of the balance sheet, which is where the big monsters are hiding.

39 responses to “No, Wait! You Got It Backwards!

  1. Many thanks for this website. I follow it religiously. I am puzzled at the fact that the governement is being very inventive in its effort to reward banks and their shareholders for making the wrong decisions. The banks can reasonably assume that the government is representing them at the expense of the tax payers. The longer the banks wait, the better, it seems,the deal becomes.

    This is not the change I can believe in. I wish to government would take over one large bank, change its management, and wipe out all the unsecured creditors and shareholders. It is the message the government needs to send to the remaining financial institutions for the latter to realize that they have act or be wiped out.

  2. “This still does nothing for the asset side of the balance sheet, which is where the big monsters are hiding.”

    In your example, the $25 billion in cash shows up as an asset. The preferred shares are the corresponding liability, which can be wiped out simply by exercising the conversion option.

    Also, I do not believe the goal here is to gift taxpayer money to the banks, exactly. (The 9% dividend and the 20% in convertible warrants ensures that taxpayers can participate on the upside, if there is any upside.) The goal is to implicitly guarantee the preferred stock and debt. These terms ensure that the preferred shareholders and creditors do not lose a single penny until we taxpayers lose our entire investment. The Treasury has made it clear that this commitment is essentially unlimited… Or at least, that is what they want investors to believe.

  3. I want to echo the comments above. The Baseline Scenario has become required reading, and furthermore, a non-economist can read it, and understand it. Of course, that will not help said non-economist sleep very easily at night, but that’s the price to pay for keeping up with this situation, I suppose.

  4. I think that the covenant restricting dividends is yet another factor which assures that these preferred shares are “puts” in “stock clothing”.

  5. Once again, an excellent post. Thanks a lot!

  6. My question is: would the conversion of these preferred shares essentially allow the banks to nationalize themselves? Citi is negotiating a $40 billion infusion, with a roughly $14 billion market cap. The conversion of those shares to common stock would give the government an overwhelming majority ownership of Citi (unless I’m missing some fundamental thing – the back of my napkin often violates mathmatical laws) So while it seems to give the banks all the options and power, is it perhaps a way to nationalize without taking the political heat for actually doing it yourself?

  7. bewilderedand indespair

    Dear James,

    Thank you!

    Would you please get your words here published in every newspaper, magazine, and journal across our country? And will you please try to go onto a few TV shows that have a major audience, FAST Money on CNBC, the TODAY SHOW, OPRAH, 60 Minutes, Meet the PRESS? I am just throwing out a few, i am sure everyone else can make a better list…maybe then, you can provide a copy of this article for all concerned citizens to send their elected officials

    ….still i am bewilderedandindespair, but want to remain hopeful.

  8. Nemo: You are right that when the government put in $25 billion, that created an asset, which is now matched with $25 billion on the liabilities side. That $25 billion to date has been called preferred stock, which means it is in Tier 1 capital but not TCE. And it is a liability in the sense that the bank is supposed to pay it back someday.

    The conversion leaves the $25 billion on the asset side, and on the liability side that $25 billion is moved from the preferred stock line to the common stock line. So it moves into TCE. But that’s just accounting. The real question is whether it makes the bank any healthier (more solvent).

    I’m doubtful. This conversion hasn’t changed the There are three conceptual possibilities. (1) The bank can pay off all its debt and its preferred stock; (2) the bank can pay off all its debt but not its preferred stock; (3) the bank can’t pay off all its debt. In situations (1) and (3), swapping preferred for common doesn’t change anything. In situation (2), the question is, would the U.S. government force a bank into bankruptcy because it couldn’t pay off its preferred stock? I doubt it. So I don’t see under what conditions the preferred-common swap increases the bank’s chances of remaining solvent (except for the ability to avoid paying the dividend on the conversion amount).

  9. I’m admittedly a layman on all this, but by my reading of the CAP term sheet the conversion price is 90 percent of the average 20 days leading up to Feb. 9. Not simply the 20-day average. Am I wrong on that?

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  11. Thanks for writing about this. This is absolutely shocking. It’s unfortunate that to explain how bad a deal this is it is unavoidable to use terms like “convertible preferred securities” and “put options” thereby making it unlikely to be discussed on national newscasts.

    Nevertheless, keep up the great work!

  12. Great explanation James. Glad you are able to digest those nasty government docs, filled with all their legalese and translate it into something understandable. It’s a huge service to the rest of the world.

    This article points out a lot of what’s wrong with how we’re looking at “fixing” the banks. Too creative, too complicated, too slow. Not enough pain for the bankers.

    The concerning part is that the policy makers are trying to pull the wool over everyone’s eyes. I’m assuming these blogs are being watched by the policymakers as well, so it should be obvious to them that they’re not acting boldly enough to Nationalize + Reprivatize a bank or two to make an example of them. It would be good for the public morale to hear of a flood of investment bankers hitting the unemployment lines. It would also be good to hear about every banking exec that paid their people a bonus for last year getting thrown in jail for giving away government money. Seems like that should have just been nearly as bad as treason. That’s my money paying for their helicopter!!

  13. Dr. Kwak –

    Thank you for the clarification. So you believe the only reason a bank would use its option to convert preferred to common would be (a) to meet certain regulatory capital requirements or (b) because it was unable to pay the dividend on the preferred stock?

    Seems an odd way to structure it, since the government itself sets the regulatory requirements, and the government could always forgo the dividend payments too if it became necessary. I wonder what they really have in mind here.

  14. By the way, in case anybody is still reading…

    Bank of America executives purchased noticeable amounts of their own stock during the last two weeks of January and the first week of February. They stopped suddenly on Feb 6, and did not purchase any more even when BAC fell to half the price they were paying before.

    I can’t imagine why…

  15. Bank of America info

    Nemo,

    Executives at BAC may have finally realized that they had been HAD by the grand puppeteers to believe that they should pay each Merrill shareholder apx. 0.85share of BAC for the acquisition :
    see 10/29/08 pre-effective amendment to S-4 SEC filing by BAC.

    Maybe suddenly on Feb 6, the GROUPTHINKTHINKTANK lies started sinking into the psyche of the BAC executives, and someone said, “the emperor has no clothes”.

  16. Dr. Kwak –

    One last thing. The CAP term sheet prohibits share repurchases without Treasury approval. So at least they plugged one of the holes you found.

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  18. I noted this “reverse” convertible feature earlier without that much surprise… this just makes the Geithner put explicit to the point of having a formal termsheet

  19. As from the others above, thank you for this post. Geithner should be getting paid by the banks, not by us. I view the government’s actions during the past six months through the lens of many poker games I have attended and also of some bad investment experiences I had years ago. As has been pointed out many times by many observers, the government (first under Bush, now under Obama) is simply continuing to double down on failed bets. Now I will assume for the sake of civility that these men are genuinely interested in the national interest (the opposite can be argued, but I won’t here for the sake of civility). Regardless of their intentions, the action of pouring money into failed business models with the expectation that when “things go back to normal, our bet will pay off” is lunacy in gambling; we all know this. When that mindset finds its way into public policy?! Well, we’re about to find out, I guess. Thanks again for this post. It helps to have a clearer picture of just what mechanisms are being used to give our money to the bankers who blew it in the first place.

  20. Prof. Kwak:

    You suggest the real monsters are in the asset side of the balance sheet. I submit they are in the footnotes!!

    db

  21. Hi all,

    I am very new to this stuff. After reading many write-ups on this subject, here is my understanding so far. Please let me know if I’ve erred. I’ll write up what I understood so far and post the questions I am confused about at the end.

    To start, all banks balance sheets must satisfy the follow equation.

    asset = liability + equity

    The assets are the mortgages (and other loans) the banks have made in the past and are holding. The liabilities are the deposits of the bank customers. The equity is whatever left over for the shareholders after the liability is subtracted from the asset. Currently the assets have shrunk due to the housing market crash and mortgage foreclosures. Liability cannot shrink since they are deposits that banks must made good on demand. Therefore, only the shareholder’s equity can shrink.

    Currently, base on estimates, asset has shrunk so much for some banks that the asset is less than liability. The bank cannot pay back all the depositors with the assets on hand. The shareholder equity is zero (cannot be less than zero).

    The US government tried to re-capitalize the banks by buying preferred shares. Unlike liability from normal deposits, the government has promise not to demand repayment (i.e. bank buy back of the prefer shares) many years from now. Therefore, the bank can use the money from the government to satisfy any bank obligations in the mean time.

    For many years in the past, the banking industry has used a measurement call Tier 1 capital to gauge the ability for a bank to satisfy demand on its liability. Currently, by the Tier 1 measure, all major US banks are in great shape. For example, Citicorp has a measure of 11.8 (in US, 8 and above is excellent). On the other hand, if we use the less common and more conservative TCE measurement than many US banks are in bad shape.

    Here are my questions:

    1. Did all the banks measure their assets valuation using mark to market?
    2. If so, are we saying we don’t believe the banks? This could affect the Tier 1 measure.
    3. Why do we suddenly feel Tier 1 is not a sufficient and should use TCE? This is one that I am really baffled by.
    4. TCE also seem unreasonably conservative. Why ignore the very valuable fact that the money from the government’s prefer share doesn’t need to be pay back for years in determining a bank’s strength? It seems perfectly reasonable to ride things out with government money and pay back the government later. Very baffling!

    It seems Citibank wanting to take advantage of the government’s plan to convert prefer shares to common shares is just smart business. A case can be made that any bank not doing so isn’t maximizing shareholder value. Is it plainly risky for a bank to pay hundreds of million to multi billion in dividends to the government when it is already financially stressed and when the payment is avoidable?

    Yes I agree the government’s plan sucks for the taxpayers.

    Thanks,
    -James

  22. yes, convertible preferred stock has some advantages over common stock. This is why convertible preferred stocks are more expensive.

  23. re “…overwhelming majority ownership…”
    Citi stockholders need have no fear. The USG stake in Citi will be non-voting; the purpose is to give them money to continue as they have.

  24. excellent description

  25. “Is it plainly risky for a bank to pay hundreds of million to multi billion in dividends to the government when it is already financially stressed …”

    We all know–wink, wink–that credit terms will be revised to less “punitive” levels on or prior to the first quarterly report following an infusion. Remember AIG?

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  27. The convertable preferred stock has no voting rights, that’s a private negotiation. I don’t see a provision for a special issue of common stock without voting rights should these “options” be exercised. Unless such a special tranch of common stock is issued on the conversion, then it would certainly have voting rights.

  28. The conversion right is backward, as you’ve noted. But the seniority positioning is backward also. Bail-out monies—USG owned preferred shares–should increase in seniority, not decrease, with ever increasing non-performance. (At least, that’s the way of the private sector.) The bail-out monies status should not reduce at the option of the bailed-out bank to that of common equity but should increase at USG option to the level of debtor-in-possession financing (that’s really what the monies are), i.e., senior to all preferred, unsecured debt, and deferred compensation/bonus pools.

    It is the end game that is most troubling here. After sinking yet more and more money into an institution, what does the taxpayer have in 6 months? Look at AIG. It has gone through $150bn, is 79.9% owned by the USG, and is now posting the largest loss in US history, $60bn for a single quarter. Now what do we do now–pump in yet more? No matter how much we think some of these institutions are “too big to fail,” some of them must. Their ability to run-up losses exceeds all reason.

  29. I agree the gov is unlikely to force CITI into bk undr scenario 2. But it could sell the preferred interest to longer term investors in tranches, thus allowing an orderly, quiet exit.

    Also, isn’t part of the goal here to bring in more private money and thus encourage/lcok-in customers/future deals/revenue for the bank so that it can survive.

    Would I rather have a ton of upside? Yes, if I were a pure financial investor, but let’s bear in mind that the USG has broader goals. Existing shareholders have been heavily diluted and so have suffered (amybe not enougg). And, officers can be punished using criminal charges that can be further explored after the present fire is reduced to a lesser risk. That rsik/club also hangs over many others.

  30. For these “too big to fail” institutions, we have share holders, creditors, and management. From my understanding, we can only punish the shareholders and the management. We cannot punish the creditors because the financial system is deeply interconnected. If we punish the creditors, these creditors and their companies will fail like dominos. Therefore, I think the US government and US tax payers have no choice but to eat the losses from transactions that were placed way before the crissis hit. I think it is these previously placed transactions that are sinking all these financial companies right now. Punishing shareholders and management will not change the depth of the hole.

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  32. “Financial Meltdown » Lunchtime Links 2-27″ is running scripts to pepper this website with links to his site. There are others.

    They are doing this as a part of search engine optimization to increase ad revenue to their own site.

    It may be a good idea to consider adding a CAPTCHA mechanism to cut down on these scum balls.

    These guys freeload off your work and also creates a distraction for your readers.

  33. The hole is too big for even the USG to plausibly fill, unless the Fed monetizes Treasury debt used for the prop-ups–if Treasury could funds for that purpose in the first place (sayeth the electorate, “No way.”).

    Creditors and shareholders for the Gothambanks knew long ago that they were not supplying long-term capital to a viable enterprise but speculating on government salvation.

  34. Lindsay Kellock

    How many informed, concerned and credible economists have taken the time and trouble to outline a course to deal with the banks and\or zombie banks? Is the message and the urgency of acting reaching the ears of policy influencers? Are blogs being read? understood? If so, why is no action taken, save the slow drip infusion infusion animating lifeless institutions? What needs to happen if it is not too late so as save the U.S. and other countries from a lost decade (or millenium)? Many many thanks to Dr. Simon and Dr. Kwak and others for helping us to grasp at least a few of the complexities of the current situation, both for the knowledgeable and the untutored.

  35. excellent…truly excellent article Dr. Kwak. This PROVES that the CULTURE of slick, investment banking shenanigans pulled off on a spreadsheet STILL EXISTS and thrives….but only at the UPPER ECHELONS of society. The monied class is still at it, I can visualize the snarky self satisfied smiles of Geithner, Bernanke, and Pandit!

    Let’s not forget that CBS News declared recently that Morgan STanley has OVER 150+ “offshore subsidiaries” in the CAYMAN ISLANDS alone! (this is where the “asset side of the balance sheet lives” while we work on bailing it out!

  36. P.S. let’s not forget the snarky smiles of Angelo Mozillo and John Thain as well:

    http://seekingalpha.com/article/98880-bank-of-america-s-acquisitions-what-was-ken-lewis-thinking

  37. I think the name of the game here is to complicate things to the point that absolutely nobody knows what is going on. If you don’t know what is going on how do you know what to complain about. If you don’t know what to complain about then usually you just go along for the ride hoping for the best. Unfortunately that is where the taxpayers are at this stage of the “rescue”.

  38. Dr Kwak-
    EXCELLENT work and thank you very much for your analysis and explanation. Just bookmarked baselinescenario and you picked up a new daily reader.
    Thanks again.

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