The New York Times is reporting that the administration is thinking of stretching its TARP funds further by converting its preferred shareholdings to common stock.
The change to common stock would not require the government to contribute any additional cash, but it could increase the capital of big banks by more than $100 billion.
I hope this is one of those trial balloons they float and later think better of. Most importantly, it makes no sense. That is, there’s nothing fundamentally wrong with converting preferred for common, but it doesn’t create anything of value out of thin air. I wrote a long article about preferred and common stock a while back, but here are some of the highlights.
- If you don’t give a bank any more money, it doesn’t have any more money. By converting preferred into common, you haven’t changed the chances of the bank going bankrupt, because its assets haven’t changed, and its liabilities haven’t changed. If it had enough money to cover its liabilities, but it couldn’t buy back its preferred shares from Treasury, it’s not like the government would have forced it into bankruptcy anyway.
- If you accept the idea that converting preferred into common creates new capital, then you are implying that those preferred shares weren’t capital in the first place. From a capital perspective, then, the initial TARP “recapitalizations” did nothing, and nothing happens until the conversion. You can’t say that JPMorgan got $25 billion of capital last fall and it’s going to get another $25 billion now just by virtue of the conversion.
- Tangible common equity and Tier 1 capital are just two ways of measuring the health of a bank. Taking money that wasn’t TCE and calling it TCE doesn’t serve any economic purpose. There is a minor benefit to the bank because now it doesn’t have to pay dividends on the preferred. But otherwise you’ve just shuffled together the claims of the last two groups of claimants – the preferred and the common shareholders. You’ve made things look better from the perspective of the common shareholders as a group, because they no longer have preferred shareholders standing in front of them, but the total amount available to all shareholders hasn’t changed.
Is there another way to explain this even more simply?
Update: I made a mistake in interpretation last night. They aren’t floating a possible strategy here; this is already what is going to happen. I forgot that the Capital Assistance Program already announced by Treasury – the mechanism for giving more capital to banks that need it after the stress tests – specifies the use of convertible preferred shares. So imagine you are a bank with $5 billion in TARP capital already. You issue $5 billion of convertible preferred under the CAP, use the proceeds to redeem the initial TARP, and then – if and when you choose – convert the convertible preferred into common. So the mechanism to do it is there already. I guess they are floating the spin to see if anyone believes this would actually make healthier banks.
Update 2: In case it wasn’t clear from the above, I don’t have any problem with converting preferred for common. I am probably mildly in favor of it, even, for roughly the same reasons as Matt Yglesias: as a taxpayer, I’d rather have the upside and control that come with common shares.
By James Kwak
The Baseline Scenario 
important, but expected news flash:
http://www.theonion.com/content/video/treasury_department_issues
“There is a minor benefit to the bank because now it doesn’t have to pay dividends on the preferred” –> Doesn’t this amount to a billion+ dollars for some banks? I think this is pretty significant.
Banks have to pay 5% dividend on the government’s preferred shares. By converting these preferreds to common, these dividend payments will stop, thus preserving cash for the banks. Despite becoming the dominant shareholder, the government will make sure it stays out of the banks’ way, it will not interfere with board and management decisions. (Just think of how much influence the government chose to apply to AIG, which is now 80% owned by the government).
So, this measure would dilute the shareholders, would deprive taxpayers from the stream of income (however modest it is), but it would help the management and the creditors by preserving bank’s cash.
ah, yes. After reading all this crazy stuff that Simon and Jame write everyday–finally something that brings us back to reality.
Is there another way to explain this even more simply?
I still don’t understand how this even creates the illusion of more capital. To me this looks like we are giving up preferred shares, which would need to be redeemed at something like face value plus unpaid dividends, for common stock that we will only get paid for at the market rate (which is most likely to be in the toilet). But they want us to believe that those shares will rebound to more than we have paid for them. Why would they do this unless they want to subordinate the taxpayer’s debt/equity to just about anybody else’s?
and if the government converts preferred to common, what price will the Treasury negotiate on behalf of the taxpayer? since the government would have us believe that this is all a confidence problem and all we need is a little financial “engineering”, i’m guessing the taxpayer can pay 2007 prices for these bank shares…
tea party anyone?
“President Obama’s top economic advisers have determined that they can shore up the nation’s banking system without having to ask Congress for more money any time soon, according to administration officials.”
Is this not just another way of saying that the Executive Branch has found yet another way to avoid the democratic process? Yet another way to do an end-run around the people’s elected representatives in Congress regarding the use of taxpayer dollars?
As I recall, issues such as these were the inciting cause for the FIRST American Revolution.
NO TAXATION WITHOUT REPRESENTATION!
I think the Administration is converting to put itself in the shareholders’ bleachers to get out of the way of creditors during the many bankruptcies ahead after the stress test results. If convert to common then at bankruptcy – Taxpayers lose; creditors win. If not converted to common – Taxpayers in line with other creditors (some upside); shareholders wiped out. Hopefully enough zombie banks fail to cleanse the system. Not likely.
Nate,
It is the same strategy of making the bondholders whole by subordinating taxpayer claims that the gov is using with GM and Chrysler.
Get support in all communities to tell our representatives that we need to:
1) Revoke the Federal Reserve Act:
Restructure the money system to not be run by private banks with primary dealer representatives…and all the conflict of interest and market manipulation that that implies. If we don’t do something soon, the next step is global world currency run by a global reserve which just so happens to be run by our 12 private reserve banks and their other banker friends around the world.
2) Require an immediate formal (non mock) investigation into the lehman/aig/ tarp mess and hold paulson and bernake under proper investigation for the alleged self dealing that the events since at least fall represent.
Require a full investigation of all owners of Lehman Credit Default Swaps to see the relationship between the main owners and the decision to save AIG. If contracts are missing, this needs to be discovered.
3) Require full transparency immediately for all bank holding companies….let the market be a market, instead of a pretend representation of what our governments wants us to believe. A more careful look at accounting and the lessons from ENRON, Worldcom, Globalcrossing et al, and how accounting fraud enabled these disasters, then look at the similaries to what is going on with the banks that are under the governments protective care.
If you accept the idea that converting preferred into common creates new capital, then you are implying that those preferred shares weren’t capital in the first place. From a capital perspective, then, the initial TARP “recapitalizations” did nothing
Not true; the initial TARP preferred shares were Tier 2 capital, which doesn’t have the same “cushioning” effect as Tier 1 capital. Converting to common equity, which is full Tier 1 capital, will definitely improve the financial health of the bank, but will mean that Uncle Sam now moves to the front in absorbing the losses.
From a capitalization standpoint, the initial decision was silly, but politically, Paulson had no other choice. Given public sentiment about the Bush Administration and Big Business, I don’t think he could have gone with a common equity stake, which would have been perceived as a boon to the banks. So he went with those damned funky preferred shares.
While preferred shareholders are better off in a liquidation than common, it’s only a tiny degree. And if one is talking about liquidating Citi in this environment, the assets will only fetch firesale prices, meaning that the chances of any residual to the preferred are practically nil.
In the end though, isn’t this just an accounting shell game? We are not really injecting more money into the banks. Rather, aren’t we just converting a LOAN of taxpayer money into a theoretically retractable GIFT of taxpayer money?
James,
Thank you for bring this article to my attention. Nevertheless, I could not disagree with you more.
Preferred stock is senior to common. Managers maximize the value of common stock. Limited liability means that a distressed bank will have perverse incentives until it has enough common stock to absorb those losses. Managers running mega banks with too little common equity will be tempted to make speculative loans and shift those losses onto senior creditors (preferred stockholders and bondholders). With too little common equity banks will pass up good loans because too many of the gains are realized by preferred stockholders and debt holders.
As long as the government gets a decent conversion price that reflects the market value of their preferred holdings, converting preferred to common stock is a great idea that will improve lending incentives. My research shows that common stock improves lending incentives for troubled but solvent banks. Preferred stock is too much like debt to encourage banks to make good loans. The government could sell its common stock holdings immediately after the conversion (to diffuse any fears of government ownership) and lending incentives would improve. It doesn’t matter who owns the common stock to see improved incentives. See my research at http://ssrn.com/abstract=1336288 and http://ssrn.com/abstract=1321666.
If a bank doesn’t pass the stress test, converting preferred to common shares is all smoke and mirrors (no interest payments for taxpayers and more risk). This is essentially a backdoor de facto nationalization with taxpayer money that may never be recouped. The financial crisis has been mismanaged and the magnitude of the problem, and growing taxpayer apathy, is dramatically changing the options available.
I would rather see temporary nationalization, reorganization, recapitalization, and re-privatization of the banks that are technically insolvent.
The entire banking situation is looking much worse than just 6 months ago. The banks looked desperate for the FASB mark-market rule change. The current proposed actions leave me with the impression that the banking situation is more dire than many believe.
Consumer loan defaults are increasing (auto, credit card, boats, etc) and the high foreclosure rates will continue (peaking Q3 09?); additionally, the commercial market appears ready to implode. Consumers are deleveraging, saving, and spending with austerity.
American taxpayers, conservative and liberal, are getting mad. County, city, and state revenues have dropped and most have recommended increasing taxes, fees, or other licensing revenues; which will snuff-out the benefits from much of the Federal stimulus spending. The pay and benefit gap between public employees (county, city, state, and federal) and the private sector continues to expand after years of increasing services and salaries; and, for a few states, the rapid previous expansion of higher education facilities/salaries are not sustainable during the current recession without significant cutbacks.
Cui bono? Not the taxpayer. A paradigmatic shift of taxpayer opinion and attitudes is occurring, a shift that will be felt at the ballot box. The public anger is palpable and growing.
Wow. Great minds think alike.
http://certainruin.blogspot.com/2009/04/strange-nytimes-article.html
Welcome to Transparency You Can Believe In!
Eugene,
you nailed the real reason they are doing it. This allows the banks to rip off the taxpayers again as I’m am sure the government will have to pay above market prices for the common shares. This whole thing is one giant rip off.
Yes, but the actions you refer to above would require telling the truth, doing what is right, being honest about the issue, would NOT protect the big politicians, would NOT protect the big political contributors, and may actually HELP the situation.
That’s clearly NOT going to happen in America. That’s just not how it’s done. Reality….it’s tough sometimes, but it’s still truth.
AA
It’s difficult when reality finally sets in, isn’t it?
AA
America, you did this to yourselves. You trusted the politicians, the bankers and the elites and they have proven (again) that they can’t be trusted. It’s the nature of the beast. The really amazing thing is that this didn’t have to happen….but here we all are.
Enjoy the result.
AA
All the big banks already have great looking Tier 1 and TCE numbers. Why is that sufficient in the past but isn’t good enough this time around?
Seems to me, the conversion’s goal is to make these numbers even better looking.
I think the government is also trying to make the banks more attractive to new investors. The government has already made clear the first place any problem bank (base on stress test) should look to raise capital is from private investors.
In response to your question:
Yes, “shell game.”
I agree, that is the one concrete benefit to the bank (seen as an enterprise and not from the perspective of one class of shareholders). But there is a big difference between (a) it saves $5 per year in dividend payments and (b) it creates $100 in new capital out of thin air.
It will almost certainly be the average price over the 20 days before February 10. That’s the conversion price for the convertible preferred shares that will be granted as part of the Capital Assistance Program. February 10 because that was the day Geithner announced his Financial Stability Plan. I haven’t checked, but those prices are almost certainly below today’s prices.
Professor Wilson,
“My research shows that common stock improves lending incentives for troubled but solvent banks”
The key word here is solvent.
Furthermore, who do you want these banks to lend to? Credit-worthy borrowers wanting to take on more debt are already able to do so. Most borrowers are looking to reduce debt.
What do you think will happen to bank share prices and TCE when the government decides to sell right after the conversion?
With regards to explaining more simply – The government has decided to absorb more future risk instead of injecting more cash.
From a short term political perspective, this may be the advantageous move. They get the “win” of the appearance of no more taxpayer cash being handed over to banks. Few understand the transaction that has taken place anyways. One day, the common stocks of Citi and BoA will be worthless, but at least they kicked the can down the road. In the meantime, they’ve opened the window for entities like sovereign wealth funds to negotiate attractive guaranteed revenue streams. The real assets of banks will remain in private hands. Actually the more I think about this, the more outrageous it is. We’ve introduced huge new moral hazard into the banking system. Shove your risk over to the U.S. government free of charge. Outrageous, outrageous, outrageous.
Liquidation aside, this is really about what a prospective preferred shareholder can negotiate once the U.S. government relinquishes its preferred status. The fact that liquidation would bear few scraps would be priced into a new preferred stock offering. How much would the banks have to pay for a new injection? 10%? 12%? 15%? One thing’s for sure though, the banks can negotiate a more attractive price now that the U.S. Government is thinking about becoming sucker numero uno.
there is plenty of capital in banks if you count what the banks owe bondholders. if you could find a way to get the bondholders to downgrade their claims to equity then the banks would be fine.
this is often called ‘bankruptcy’ or ‘recapitalization’. it’s also a part of ‘good bank’ / ‘bad bank’
isn’t that what this proposal does?
http://angrybear.blogspot.com/2009/02/treasury-and-citi.html
If you don’t give a bank any more money, it doesn’t have any more money.
True, but adjusting the capital structure might make the bank more willing to lend the money it has. Preferred stock capital has to be repaid eventually; common does not. Personally, I would be more willing to lend out money that is “free and clear” than money I know I have to return to you someday. Wouldn’t a bank?
At the risk of discrediting myself by being a gullible distributor of rumors, what do you all make of this:
http://turnerradionetwork.blogspot.com/2009/04/leaked-bank-stress-test-reults.html
I don’t necessarily believe that they actual got a peek at the real results, as the details seem to have been pulled verbatim from this reuter’s report: http://www.reuters.com/article/pressRelease/idUS180066+06-Apr-2009+BW20090406
However, I also don’t necessarily disagree with the thesis (though the part about derivatives counterparty credit risk is a bit naive…any trading firm is going to have trillions of notional outstanding of derivatives exposure). If the banking sector is actually as underwater as these reports imply, maybe the gov’t is doing the only thing it can to help shore up these banks without biting the bullet and actually nationalizing them. Why won’t they just nationalize all the banks that are underwater? Maybe they think that global investor’s will realize that the US Treasury is also insolvent, spark a run on the dollar, and send us into an apocalyptic tailspin…
yes. converting a loan to a gift means that the bank can keep the money. preferred holders have a claim to be repaid, equity holders do not. that sounds real to me, not just ‘accounting’.
if the conversion price is lower than the current market price, why wouldn’t a smart bank just offer up a secondary? Maybe Goldman is “that good”…
TARP preferred is Tier 1 by decree. See page 2 of the term sheet.
More importantly, what is a cushion? It’s someone you don’t have to pay back. An ordinary debt-to-equity conversion increases your cushion, because you have to pay back debt, but you don’t have to pay your common shareholders anything.
But converting Treasury preferred to common doesn’t have a cushioning effect. Everyone already knew that if push came to shove, the banks wouldn’t have had to buy Treasury’s preferred back. So converting this particular preferred stock to common doesn’t reduce the amount of obligations you have to pay back, and hence it doesn’t increase your cushion.
Critics of nationalization will say that the govt. is acting irrationally – a move to convert its preferred (fake equity) in to (real equity). The stock market will continue to frown upon such a move, even though its required set things right. The treasury can only assert its ownership rights once it has the resolve to takedown the pundits of wall street. Until then, we will continue to move towards a “lost decade”.
Heh, it may be good to put up an opposing view to balance things out.
http://mast-economy.blogspot.com/2009/04/bank-crisis-is-over.html
This link does include source information. For what is worth, I think Turner Radio Network is fear mongering. The biggest give away is #7 on the list. On the other hand I don’t believe we are out of the woods yet either.
This is a good move for the gov because it is operating on the level, and saves the bank a few bones in the end. NYT seems to have missed the point, I think.
what about the other holders of recent preferred issues – do they have to convert as well? i remember something like this in the Citi round, where for every share the treasury converted another holder had to convert.
Do you get the upside from preferred shares in the CAP program if they are only converted at the option of *the bank*? If common becomes significantly more valuable, why would the bank do a conversion?
The suspense and drama is a lot of fun! This is way better than going to a scary movie!
http://www.bloomberg.com/apps/news?pid=20601087&sid=aZCb6UIETseA
Is there an angle here, where it makes it easier/cheaper for banks that want to repay TARP funds to do so? Or if we operate under the assumption that they are going to repay in the near future, does it make them look better if they convert the stock to common before they repay?
Thank you AA, I know, but honestly, how can anything really get better unless the system is redone to properly reflect what is in the best interest of the country, not the private bankers? Maybe IMPOSSIBLE to imagine, easier to see the resistance and believe impossible, but sometimes it takes the impossible happening for things to be made better……who would have ever believed women could vote, and all the rest that the courage of American’s have achieved? I know you don’t hate us otherwise you wouldn’t waste your time with your thoughtful remarks!!! And by the way, thank you very kindly AA!
Yes, I completely agree on that point. Krugman has a good example on this (http://krugman.blogs.nytimes.com/2009/04/20/preferred-shares-to-common-equity-an-analogy)
Thank’s…………
so,so
“And it opens the possibility that the government could use its large stake in the firms to influence board of directors composition and otherwise exert control over the firms.” (MY) It doesn’t seem necessary for the government to convert to common stock in order to gain voting rights. The U.S. Government carries a bigger stick than the average stock holder. After all, a call from the President got Rick Wagoner to step down. I don’t see why so-called “voting power” is a legitimate concern for Treasury.
“The 19 big banks have received more than $140 billion from the Treasury’s financial rescue fund, and all of that has been in exchange for nonvoting preferred shares that pay an annual interest rate of about 5 percent.” (NYT) If the dividend cash flow savings is what’s going to help the banks reach prosperity, isn’t that the definition of holding on by a thread?
But what alarmed me too was; “[The Treasury as controlling shareholder] could lead to increasingly difficult conflicts of interest for the government, as policy makers juggle broad economic objectives with the narrower responsibility to maximize the value of their bank shares on behalf of taxpayers.” (NYT) Is this a substantial conflict of interest or am I just growing paranoid?
In addition, with the benefits to the banks from this conversion, what concessions are they making in exchange – or dare I ask?
saw your article baseline scenario. Q-is the Tarp money for C currently on balance as equity or liability.
I think i lost a bet on this.
If you take something a firm has to pay, and turn it into something the firm doesn’t have to pay, you haven’t changed the chances that it will go bankrupt. Hmm. That’s going to take some more explaining.