Bank recaps: Why the preferred stock swap makes sense

By Felix Salmon
April 20, 2009

Paul Krugman and James Kwak are unhappy with the way in which the government is proposing debt-for-equity conversions as a way of recapitalizing the banks — mainly because they don’t consider the preferred stock bought initially under the TARP program to be debt in the first place, and if you look at it as equity, it’s true that no one benefits much from an equity-for-equity conversion.

I’m slightly more constructive, because I never really considered preferred stock to be equity in the first place. It looks like a bond, paying a fixed coupon, and it serves to increase the leverage of common shareholders, just like debt does. If the government converts it into pure equity, then that leverage goes down, which is a good thing, and the bank in question no longer has to make those coupon payments.

More to the point, if a bank ever defaulted on its preferred coupons, that’s game over right there: the FDIC would never stand for such a thing, and would take it over. In that sense, preferred stock can’t really be considered risk capital, which is the intuitive definition of equity. Common stock, by contrast, is risk capital — and if the government’s main aim here is to get the banks lending again (and according to the WSJ today, they’re not), then you want the government capital to be as junior as possible.

Indeed, this is quite close to the general plan I’ve been sketching out for some months now: massively dilute the common shareholders, impose a haircut on the preferred, and leave the senior unsecured largely untouched. The only alternative would be to inject yet more hundreds of billions of taxpayer dollars into the banking system, without any real indication that the money would be put to good use. Congress doesn’t want that, and neither do I.

9 comments

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I dont understand why there is such a need to absolve the creditors of their potential losses. In doing so we are only laying the groundwork for a future replay of this crisis. Creditors need to be incentivized to police their exposures rather than leaving it to an inadequate regulatory system and underinformed equity holders. Without downside creditors will naturally (and rationally) overlend and ignore risks. Furthermore bank equity holders and certainly the banks employees are also encouraged to overplay their hand in the hope of levered returns without interested creditors to police them. Thus we have a socialized system regardless of the optics, with even larger risks and only a proven disfunctional regulatory system to police it and protect the tax payer.

Posted by dazedandconfused | Report as abusive

That would be a great idea, Felix, if only wholesale theft by the Federal Government was permissible under the Constitution. Drat!

“The only alternative would be to inject yet more hundreds of billions of taxpayer dollars into the banking system, without any real indication that the money would be put to good use. Congress doesn’t want that, and neither do I.”

There’s another point to doing this, and that is that it’s an easy form of nationalization. That’s good. Let me say it again:
Nationalization.

For all I know, that’s what the government would really like. Perhaps they’re like the nun and her ruler in my short spell in Catholic School.

“I take no pleasure in being forced to do this young man,” she would say.

“Of course not luv”, I would say to myself. “Any more than I take pleasure in pissing you off.

I want the banks to fear an itchy finger. Here’s why:

http://www.nytimes.com/reuters/2009/04/2 0/business/business-banks-europe.html?re f=business

“That dilemma faces many banks. Dozens of lenders in Europe and the United States have been shored up with rescue funds from governments, but many are keen to limit their reliance on the state and selling profitable units is the most realistic alternative.”

Between:
1) Caps on salaries
2) Government taking control

there’s been a fire, although I’d prefer a conflagration, lit under the asses of these bankers. I don’t want them using taxpayers money. Call me crazy.

There is an oddity to these asset sales though: they seem to be largely foreign assets, and deals made in the last few years. It’s as if we were buying up the world, and are now being forced to sell it back at a loss.

This is a nice analysis. It is also consistent with my research findings. See http://www.businessinsider.com/krugman-n ew-treasury-plan-is-just-shuffling-deck- chairs-on-the-titantic-2009-4.

I’m not sure what you mean by a bank defaulting on its preferred. I believe that most bank preferred is non-cumulative, and that they are under no legal obligation to pay a preferred dividend. The only rule is that if they pay a common dividend they have to pay the preferred dividend too. So technically, not paying the dividend is not a default – this is why preferred is more like equity than debt.

Posted by Nate | Report as abusive

if we let the banks convert the preferred shares to common, we will be giving up the preferred dividends, which for BofA’s just announced qtr, amounted to $1.4B. Having to pay dividends like this to the government keeps the bank from wasting more money than it normally would. Plus, the govt can use the money.

Instead of converting the preferred to common, can’t we just let the banks include the preferred stock in their calculations for determining how healthy they are? The government shouldn’t convert the preferred to common until it is ready to sell those shares on the open market. As long as the govt has an at-risk stake in a bank, it should receive some kind of premium, otherwise it’s just one more gift to a group that doesn’t deserve it.

Posted by KenG | Report as abusive

I have to agree with Felix on this one.

Free cash flow analysis says that if banks are required to pay out more than they take in each quarter than they are insolvent. Adding to the required bank payments at this point does not help them very much is they are possibly cash flow insolvent. Allowing banks to count prefered as capital only helps regulatory ratios. If once all of the losses are realized, the banks interest income exceeds their interest expense plus prefered dividend then they are fundamentally in trouble and the regulatory ratios will not matter. Stoping prefered payments is technically possible, but could have practical implications(it would be similar to a bank CEO saying “yeah, we think that we might fail the stress test).

Posted by Paul A | Report as abusive

In my haste I made a typo, this:

“If once all of the losses are realized, the banks interest income exceeds their interest expense plus prefered dividend then they are fundamentally in trouble and the regulatory ratios will not matter.”

should read:

” If the banks interest expense plus prefered dividend exceeds their interest income, regulatory ratios will not matter.”

Keep up the good work Felix!

Posted by Paul A | Report as abusive

Felix: the CPP money is at the holding company level, which the FDIC has no power over. In fact, the two Lehman bank subsidiaries are still alive, believe it or not… So long as the bank subsidiary still has capital, the FDIC doesn’t really care what happens to the holding company.

Nate: the CPP preferred shares, per their term sheet at http://www.treas.gov/press/releases/repo rts/tg40_captermsheet.pdf, “will pay cumulative dividends at a rate of 9% per annum, compounding quarterly.”

Posted by Andy | Report as abusive