For a complete list of Beginners articles, see Financial Crisis for Beginners.
You may have seen in the news that the government is thinking about exchanging its “preferred stock” in Citigroup for “common stock.” Here’s one of many articles. Which, if you are at all sensible and have any sense of proportion in your life, should be complete gobbledygook. The first part of this article will try to explain the gobbledygood; advanced readers can skim it. The second part will offer some of the usual commentary.
Banks, like all companies, have balance sheets. On one side they have assets – stuff they own. On the other side they have liabilities – money they owe other people – and equity. Equity can be thought of in two ways. First, it is the money that the initial owners put in to start the business; before you can borrow money from someone else, you usually have to have some money or other assets of your own that you put in. Added to that money are retained earnings – all the profits the company has made but has not paid out to the owners as dividends. Second, equity is what is left over after you pay off all your creditors. If you sold the assets and paid off the liabilities, the rest would go to the company’s owners.
That equity “belongs” to the owners of the company; if it’s a publicly-owned company, those are the shareholders. The market value of the equity is the total amount that people would pay today to own all of that balance sheet equity: it’s the total number of shares times the share price. The market value of equity is generally different from the “book value” (balance sheet value) of equity, because if you own a company, you own not only today’s equity, but also all the profits the company will make in the future. Under certain circumstances the market value of equity can be less than the book value of equity – that’s the case if investors think that the company’s management is destroying value, or that the book value of equity on the balance sheet inflates its true worth.
The complication is that there are different kinds of equity. The way to think about this is to think about the various ways that companies can raise cash from investors. At one extreme there is secured debt: the company goes to a bank, takes out a loan, and pledges some of its assets as collateral. If it doesn’t repay the loan, the bank gets the collateral. Then there is unsecured debt: the company issues a bond, which is just a promise to pay in the future, and the investor pays money for this bond, hoping to be repaid with interest. At the other extreme there are common shares. These give you no rights in particular, except the right to control the company, through the board of directors. Conceptually, the common shareholders own the equity, and benefit from the future profits, but the company has no obligation to give them any of the equity, or to pay out any of the profits as dividends. Then in between debt and common shares there are these things called preferred shares, which come in many flavors. Preferred shares are like debt: they may pay a required dividend, which is like interest on a debt; there may be rules on when they have to be bought back by the company, such as in case of a major transaction. They are also like equity: in case of bankruptcy, preferred shareholders only get paid back only after all the debt holders have been paid back; in some cases, preferred shares can be converted for common shares at a predetermined price, which allows preferred shareholders to benefit if the common stock goes up in value.
In summary, there is a spectrum of instruments through which companies raise money, and these instruments have differing priority in making claims on the company. They also differ in how likely the investor is to be paid back. Secured debt comes first, common shares come last, and everything else comes in between.
Trust me, we’re getting closer to the question I started with.
Ordinarily, you don’t need to debate whether preferred shares should count as debt or equity. However, for banks in particular, there is a concept called capital adequacy. A capital adequacy ratio is the ratio between some measure of capital to total assets. Imagine for a moment that there was only one kind of debt – say, deposits – and one kind of capital – ordinary shares. Say my bank has $100 in assets. As we all know, assets can go up or down in value. If I have $90 in debt, then I have $10 in capital, and my ratio is 10%. This means that my assets could fall in value by up to 10% and I would still be able to pay back my depositors. If, instead, I have $99 in debt, then my ratio is only 1%. If my assets fall by more than 1% in value, I won’t be able to pay back my depositors, I’ll be insolvent, and the FDIC will take me over so it can pay off the deposit guarantees at minimum risk to itself. This is why the capital adequacy ratio matters, especially to bank regulators. What minimum capital ratios should be is a complex topic, most of which I will avoid, but you can see why they matter.
The part I can’t avoid is how the capital – the numerator of the ratio – is calculated. As I said above, there are many different types of capital. Besides common shares and preferred shares, believe it or not, you can count deferred tax assets (credits you gain by losing money in one year, which you can apply against taxes in future years where you make money) as capital. One commonly used measure of capital is called Tier 1 Capital, which includes common shares, preferred shares, and deferred tax assets. A less commonly used measure is Tangible Common Equity (TCE), which includes only common shares. Obviously, TCE will yield a lower percentage than Tier 1.
Which of these measures is better? That’s sort of an arbitrary question. The fact that you change the numbers you type into your spreadsheet doesn’t change the actual health of the bank any. They just measure different things. Each one measures the ability of the bank to withstand losses before its ability to pay off its liabilities starts getting compromised. One difference between the two is whether you count preferred shares as liabilities, which depends on how bad you think it is that preferred shareholders don’t get their money back. Another difference depends on what you think the deferred tax credits are worth in a worst-case scenario. In any case, the skeptics, like Friedman Billings Ramsey, have been insisting since the beginning of the crisis that TCE is the proper measure of bank solvency. And most immediately, Tim Geithner has said that the new bank stress tests will focus on TCE. So if your bank doesn’t have enough TCE, it will fail the stress test, and then . . . who knows what the administration has the stomach to do.
Getting back to the current situation . . . The initial government investments in Citigroup, back in October and November, were in the form of preferred shares. Between the two bailouts, the government put in $45 billion in cash and got $52 billion in preferred stock (the $7 billion difference was the fee for the guarantee on $300 billion of Citi assets). That preferred stock was designed to be much closer to debt than to equity: it pays a dividend (5% or 8%), it cannot be converted into common stock (so it cannot dilute the existing shareholders), it has no voting rights, and it carries a penalty if it isn’t bought back within five years. In fact, it is hard to distinguish from debt, except perhaps for the fact that, if Citi defaults on it (cannot buy the shares back) we don’t need to worry about systemic instability, because the government can absorb the loss. As preferred stock, these bailouts boosted Citi’s Tier 1 capital, but not its TCE.
Because of the newly perceived need for TCE, the bailout plan under discussion is to convert some of the preferred stock into common stock. Citi wouldn’t actually get any new cash from the government, but it would be relieved some of the dividend payments (currently close to $3 billion per year), and of the obligation to buy back the shares in five years. (For the impact on Citi’s capital ratios, see FT Alphaville.) This is a real benefit to the bank’s bottom line, and hence to the common shareholders. At the same time, though, Citi would issue new common shares to the government, diluting the existing common shareholders (meaning that they now own a smaller percentage of the bank than before). In theory, the amount by which the shareholders in aggregate are better off should balance the amount of dilution to the existing shareholders.
The trick is deciding what price to convert the shares at. All of Citi’s common shares today are worth around $12 billion, so if you converted $52 billion of preferred shares into common, the government would suddenly own over 80% of Citi. (In the conversion, you divide the value of the preferred stock you are converting by the price of the common stock, and that yields the number of common shares the government now owns.) The Geithner team is still continuing the Paulson policy of avoiding anything that looks like nationalization, so the talk is that the government ownership will be capped at 40%; that means the government could only convert about $8 billion of its preferred stock. There will probably be some clever manipulation of the numbers to say that the preferred stock is actually worth less than $52 billion, or that it should be converted at a higher price than the current market price of the stock. (This seems like a blatant subsidy to me, since new investors buying large blocks of stock in a public company typically pay less than the current market price.) There is also talk of trying to get some of Citi’s other preferred stock holders to convert as well, because the more they convert, the more common shares, and hence the more the government can have without going over the 40% limit.
I still don’t understand why people care so much about whether the government owns more or less than 50% of the common shares. This just seems like a fig leaf. The more important issue which people can argue about is whether government is controlling Citigroup’s day-to-day operations. (Some say that’s good, some say it’s bad.) According to The New York Times, this is already happening. Alternatively, if you want to minimize government control, the government could tie its own hands; for example, no matter what its percentage ownership, the government’s stock purchase agreement could say that it has the right to appoint a minority of the board of directors but no more than that.
I think the situation we want to avoid is what is going on at AIG, where the government owns 80% of the company but still seems to be negotiating at arm’s length with the company. This is the worst of all worlds, because even though it already bears the vast majority of the losses, and has the power to clean up AIG (by writing down all its assets to their worst-case scenario values and then recapitalizing the firm sufficiently), the government is treating AIG like an independent entity. For example, if the government did a radical cleanup, it’s hard to see how AIG would still be in danager of ratings downgrades – which are the immediate problem it faces. But that story may have to wait for another post.
Update: Changed “private company” to “publicly-owned company” in the 1st line of the 3rd paragraph. Someday I’ll learn to proof-read before posting. Thanks to Manu for catching that.