More Accounting Games

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.

Originally published at the Baseline Scenario and reproduced here with the author’s permission.

2 Responses to "More Accounting Games"

  1. John Slater   April 20, 2009 at 10:08 am

    As I previously raised at, the real issue is whether the Treasury is committed to protect the bondholders of the big banks. There is a great deal of capital in the banking system already in the form of unsecured debt. In a normal world when a company goes broke some or all of the debtholders’ interest will ultimately be converted to equity capital either in bankruptcy or in an out of court restructure. The current issue of The Institutional Risk Analyst( makes a very interesting proposal for conversion of Citibank debt into equity, which would address the capitalization issue once and for all. It’s time the Treasury explains in clear English why they are electing to further commit taxpayer funds to bailing out the bondholders.

  2. 2cents   April 20, 2009 at 12:09 pm

    I had psted this yesterday over @ Nouriel’s blog.Am I missing the picture here?I read where the Obama administration says it will not need any additional funding from Congress anytime soon. (NY Times) Via accounting regs, the bank’s capital can be expanded by converting the existing government gratuity to common shares! Mind you, no additional monies will be received, but via the magic of accounting, the bank will nonetheless expand its regulatory capital!The government FED/Treasury can then parlay those common shares into collateral to loan to regional banks as the CRE market tanks! Brilliant! We’ll just shift the ponzi pyramid to the left a little, add a little government leverage and everything will work out just fine!This is being implemented because of political constraints, but I’m afraid that when the moment comes it will go something like this: My fellow Americans the government has taken the extraordinary step of trying to save the financial system by backstopping the financial economy with the full support of the government. As you know, my fellow citizens, you are the ones providing that ultimate backstop. So due to extraordinary circumstances you are now the majority holders of the equity in the financial system! As any rational investor knows, there are market ups and downs. We believe that we have positioned the taxpayer in a very favorable long term position, and given time the taxpayer will receive a dramatic windfall via this investment. Think of a future where your grandchildren look back and realize what a fortunate position they are in that taxes have been reduced to nearly zero because of the windfall we are positioning them for at this very moment.Of course there are those who seem to believe that this is all a complete folly. I ask you my fellow Americans, do you want to see your grandchildren live virtually tax free, or do you want to cash out of this investment now and see your taxes double and your grand children’s taxes quadruple?Amazingly, this hope for a better future is what will sell. Never mind that there will be conflicts of interest for the government as they juggle the responsibility to maximize the value of their bank shares on behalf of taxpayers verses the larger economic health of those same taxpayers. The reality is that it is mathematically impossible to enhance the return on the bank “investments” while also enhancing the overall economic health of the average American.