Converting TARP's Preferred to Common Stock - Great Idea

The New York Times reports that the Obama administration is floating the possibility of converting their preferred stock bought with TARP funds into common stock. If done right, converting the taxpayers preferred stakes into common stock could be the easiest and lowest cost way to nurse the banking sector back to health.

Managers maximize the value of common stock. Preferred stock is senior to common. Limited liability means that a distressed bank will have perverse incentives until it has enough common stock to absorb the possible losses from being in business in an uncertain environment. Managers running 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 quickly after the conversion (to diffuse any fears of government ownership). Lending incentives would improve regardless of who owns the common stock.

For mega banks that are probably on the list of Treasury Secretary Geithner's and Ben Bernanke's list of institutions that are "too-big-to-fail", taxpayers could gain enormously from a preferred to common conversion. That extra common stock cushion will make those "too-big-to-fail" institutions less likely to take bad bets that taxpayers end up paying for. Nevertheless, if the Obama administration or regulators believe that a bank is truly insolvent, only some form of receivership-type restructuring can lift that bank from the ranks of zombies.

My research papers on this topic are "Debt Overhang and Bank Bailouts" and joint work with Wendy Yan Wu "Common (Stock) Sense about Risk-Shifting and Bank Bailouts"

Disclosure: I only own broad-based index funds. I have no positions outside of index funds in financial firms' stocks or other securities.

Comments

[Carolina1954:]

"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." Ridiculous. Preferred stockholders get their fixed dividends and debt holders get their fixed coupons. Gains lost because of passing up good loans will be entirely at the expense of common stockholders. Mr. Wilson should enroll in a good accounting 101 class.

Apr 20 05:23 AM

[mikemichaelson:]

common stockholders will get heavily diluted should this happen.

Apr 20 07:25 AM

[Stewie:]

"Managers maximize the value of common stock. " Are you stupid or something ?

Apr 20 08:15 AM

[CautiousInv...:]

I don't want to sound harsh but you painting a pretty picture that is at odds with what is going on.

This is being done because Treasury lacks the funds to purchase more preferred. They are almost out of money and do not want to go back to Congress; and the banks in question cannot raise needed capital in private markets.

As to making great loans in the future, the banks have already made the loans and now Treasury is helping them engineer a means to have sufficient TCE to simply survive.

How great the idea depends first and foremost upon your belief of state ownership in banks, the length of time, the involvement of the state in bank operations and bank lending practices.

To make this good for the taxpayers, the conversion price should be painful for existing shareholders.

Apr 20 08:26 AM

[dutchr@bell...:]

This is a ploy by Obama to take-over the banking system. This control could lead to European-style socialism, which puts our democracy in jeapardy. Chris Dodd & Barney Frank will be calling the shots instead of the directors & officers.

Apr 20 10:42 AM

[BSexposer:]

Wow - what a bunch of NONSENSE. This is why you can NEVER trust anything on Seeking Alpha - sad, really.

Apr 20 10:50 AM

[BSexposer:]

"Disclosure: I only own broad-based index funds"

= Disclosure: I own a boatload of SKF and am hoping the govt dilutes the banks to zero.

Apr 20 10:51 AM

[skwestorange:]

I think the author's position is based on the fact that corporate executives and managers' compensation includes RSUs, options and stock awards (not fixed income instruments). Hence they are bound to be more inclined to take care of their own interests.
SK

Apr 20 12:35 PM

[HBWOW:]

It is obvious this author must have been a former congressman as it mirrors the lack of logic and understanding that is so prevalent in Washington and too many of our investment and banking "executives" as well.
IS THERE NO HOPE???

Apr 20 01:13 PM

[cljenn01:]

"...common stockholders will get heavily diluted should this happen."

You'd prefer bankruptcy?

"This is a ploy by Obama to take-over the banking system. This control could lead to European-style socialism, which puts our democracy in jeapardy. Chris Dodd & Barney Frank will be calling the shots instead of the directors & officers."

If only. Summers & Geithner would love to back dump-trucks full of no-conditions cash up to the banks if they could. Do you think they enjoy having to constantly invent new methods to obscure sticking taxpayers with multi-trillion dollar losses? And what has the heavy hand of the U.S. Government done as majority shareholder in Citigroup? Wildly overpay for shares? Convert our preferred stock into common? Face it, the banks nationalized the federal goverment years ago and now they're just showing off.

Apr 20 04:02 PM

[kruser53:]

Linus - - -

You wrote: "...common stock improves lending incentives for troubled but solvent banks. Preferred stock is too much like debt to encourage banks to make good loans. "

I draw your attention to "...troubled but solvent..." Aye, there's the rub. No one knows who's merely troubled and who's insolvent.

Apr 20 04:16 PM

[Stewie:]

Yeah that would be a valid point except managers bonuses are rarely based on profit but instead usually tied to revenue growth. This of course doesn't always mean more profitability. It also the same formula used in many Executive compensation packages.


On Apr 20 12:35 PM skwestorange wrote:

> I think the author's position is based on the fact that corporate
> executives and managers' compensation includes RSUs, options and
> stock awards (not fixed income instruments). Hence they are bound
> to be more inclined to take care of their own interests.
> SK

Apr 21 06:19 PM