TARP Funds to Common Stock: More Accounting Games

By James Kwak

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?

Comments

[battman:]

It seems the whole thing about fudging and manipulating to make things look better then they are is still very much alive.
I'm glad these select few know what's best for us. This way we don't have to think. Thinking hurts.

Apr 20 09:04 AM

[levin70:]

You have just discovered the six month lag effect. Policy making decisions are about 6 months behind what gets whined about on this site. If you go back six months, you will remember the big whine threads here about TCE being the be-all and end-all of measuring bank solvency.

Policy makers read all that, took six months to digest what was said, and have decided that yep thats right, those were good arguments and now they will be instituting those policies.

Of course, the investment community, including those on this site, moved past TCE as an issue about a week after the November lows. Welcome to wonderland

Kind Regards

Apr 20 09:11 AM

[John Lounsbury:]

If Houdini were to be reincarnated today, he would be an accountant.

Apr 20 09:12 AM

[jratl:]

There is the possibility that people in Washington might be more interested in holding voting shares as a way of influencing policy within banks.
That's a silly idea, Washington would never put power and influence ahead of sound fiscal policy.

Apr 20 09:19 AM

[mac123449:]

The Turner Radio Network has obtained "stress test" results for the top 19 Banks in the USA.

The stress tests were conducted to determine how well, if at all, the top 19 banks in the USA could withstand further or future economic hardship.

When the tests were completed, regulators within the Treasury and inside the Federal Reserve began bickering with each other as to whether or not the test results should be made public. That bickering continues to this very day as evidenced by this "main stream media" report.

The Turner Radio Network has obtained the stress test results. They are very bad. The most salient points from the stress tests appear below.

1) Of the top nineteen (19) banks in the nation, sixteen (16) are already technically insolvent.

2) Of the 16 banks that are already technically insolvent, not even one can withstand any disruption of cash flow at all or any further deterioration in non-paying loans.

3) If any two of the 16 insolvent banks go under, they will totally wipe out all remaining FDIC insurance funding.

4) Of the top 19 banks in the nation, the top five (5) largest banks are under capitalized so dangerously, there is serious doubt about their ability to continue as ongoing businesses.

5) Five large U.S. banks have credit exposure related to their derivatives trading that exceeds their capital, with four in particular - JPMorgan Chase, Goldman Sachs, HSBC Bank America and Citibank - taking especially large risks.

6) Bank of America`s total credit exposure to derivatives was 179 percent of its risk-based capital; Citibank`s was 278 percent; JPMorgan Chase`s, 382 percent; and HSBC America`s, 550 percent. It gets even worse: Goldman Sachs began reporting as a commercial bank, revealing an alarming total credit exposure of 1,056 percent, or more than ten times its capital!

7) Not only are there serious questions about whether or not JPMorgan Chase, Goldman Sachs,Citibank, Wells Fargo, Sun Trust Bank, HSBC Bank USA, can continue in business, more than 1,800 regional and smaller institutions are at risk of failure despite government bailouts!

The debt crisis is much greater than the government has reported. The FDIC`s "Problem List" of troubled banks includes 252 institutions with assets of $159 billion. 1,816 banks and thrifts are at risk of failure, with total assets of $4.67 trillion, compared to 1,568 institutions, with $2.32 trillion in total assets in prior quarter.

Put bluntly, the entire US Banking System is in complete and total collapse.

If this is true, and this leak gains traction expect the media blitz to discredit it to be swift, ie they wall have cramer and the rest of the gang at CNBS and bloomberg radio talking green shoots everywhere and that this is total BS, at which point you know it's the truth...

Apr 20 09:32 AM

[econophil:]

If this is true, we are in deep do do!


On Apr 20 09:32 AM mac123449 wrote:

> The Turner Radio Network has obtained "stress test" results for the
> top 19 Banks in the USA.
>
> The stress tests were conducted to determine how well, if at all,
> the top 19 banks in the USA could withstand further or future economic
> hardship.
>
> When the tests were completed, regulators within the Treasury and
> inside the Federal Reserve began bickering with each other as to
> whether or not the test results should be made public. That bickering
> continues to this very day as evidenced by this "main stream media"
> report.
>
> The Turner Radio Network has obtained the stress test results. They
> are very bad. The most salient points from the stress tests appear
> below.
>
> 1) Of the top nineteen (19) banks in the nation, sixteen (16) are
> already technically insolvent.
>
> 2) Of the 16 banks that are already technically insolvent, not even
> one can withstand any disruption of cash flow at all or any further
> deterioration in non-paying loans.
>
> 3) If any two of the 16 insolvent banks go under, they will totally
> wipe out all remaining FDIC insurance funding.
>
> 4) Of the top 19 banks in the nation, the top five (5) largest banks
> are under capitalized so dangerously, there is serious doubt about
> their ability to continue as ongoing businesses.
>
> 5) Five large U.S. banks have credit exposure related to their derivatives
> trading that exceeds their capital, with four in particular - JPMorgan
> Chase, Goldman Sachs, HSBC Bank America and Citibank - taking especially
> large risks.
>
> 6) Bank of America`s total credit exposure to derivatives was 179
> percent of its risk-based capital; Citibank`s was 278 percent; JPMorgan
> Chase`s, 382 percent; and HSBC America`s, 550 percent. It gets even
> worse: Goldman Sachs began reporting as a commercial bank, revealing
> an alarming total credit exposure of 1,056 percent, or more than
> ten times its capital!
>
> 7) Not only are there serious questions about whether or not JPMorgan
> Chase, Goldman Sachs,Citibank, Wells Fargo, Sun Trust Bank, HSBC
> Bank USA, can continue in business, more than 1,800 regional and
> smaller institutions are at risk of failure despite government bailouts!
>
>
> The debt crisis is much greater than the government has reported.
> The FDIC`s "Problem List" of troubled banks includes 252 institutions
> with assets of $159 billion. 1,816 banks and thrifts are at risk
> of failure, with total assets of $4.67 trillion, compared to 1,568
> institutions, with $2.32 trillion in total assets in prior quarter.
>
>
> Put bluntly, the entire US Banking System is in complete and total
> collapse.
>
> If this is true, and this leak gains traction expect the media blitz
> to discredit it to be swift, ie they wall have cramer and the rest
> of the gang at CNBS and bloomberg radio talking green shoots everywhere
> and that this is total BS, at which point you know it's the truth...

Apr 20 09:53 AM

[Lilguy:]

Not only are the banks playing the mythical accounting and massive misrepresentation game, soon Treasury will be too--if this NYT report is any indication.

...and just who does the Treasury thinks its fooling? Not only is the absence of value in such a transition obvious, so too is the fact that the US taxpayer steps down to the bottom rung of the rights ladder in any bankruptcy of these banks. The bond holders will be made whole, the preferred stock holders may get something, and the equity shareholders--including billions of taxpayer dollars converted from preferred--will get absolutely nothing. How stupid, how disingenuous, how incredibly arrogant and untrustworthy can the US Treasury become under Geithner?

Apr 20 09:55 AM

[History Buf...:]

They can spin this any way they want to, but all it seems to be to me is more of the same we've been seeing -- privatizing gains and socializing losses. If the stress tests are as bad as what I'm hearing, most of the big banks are technically insolvent -- does it really make any sense for the taxpayers to be buying them out at this price or any other? And does switching the government from preferred to common put them lower on the totem pole in terms of repayment?

Apr 20 10:09 AM

[Zachary Sch...:]

OK, I agree with you that this move is wrong. The government should not be in the business of OWNING free market enterprises...

But as far as this "not changing anything" I think you've missed the point. Originally TARP funds were set up as a liability. That means the Banks actually have to pay this money back. Preferred shares are debt plain and simple.

Converting this capital to common equity actually takes the capital OFF the liability side and yet leaves the assets intact. This move essentially means that the banks don't have to return the capital. Instead, other common shareholders are on the hook for the capital. (I say other common shareholders because the government claims that it eventually intends to sell the shares)

Now in the case of Citigroup where the government will own 36% of the stock, that is a huge seller waiting in the wings. The common stock will have a hard time rising to a strong fundamental value when you have such a large shareholder with a stated intent to sell.

But the bottom line is that Citi is no longer liable to repay the TARP money - that's good for the long-term viability of the company, and great for existing bondholders... but it's a pretty tough pill to swallow for existing shareholders. The one good side for shareholders is that there is now less of a chance that Citi will go bankrupt leaving them with nothing.

Zach
zachstocks.com

Apr 20 10:12 AM

[User 283977:]

It appears the strategy is to partially re-inflate these companies balance sheets to provide an illusion that they are solvent. The profits being reported are actually 'laundered' taxpayers money. On seeing profits, investors are supposed to re-capitalize the companies. To those in the know, the fact that the profits are taxpayers money is irrelevant. What counts is the re-inflated stock prices.

The taxpayers investments being converted from preferred to common devalues common stock holdings while inflating preferred. So it seems this is a strategy designed to attract large player capital investments. So the taxpayers are getting the risky end of the stick. If the re-inflation fails, the large players have a 'get out of jail card'.

The next part of the accounting 'fix' concerns removal of 'mark to market' accounting, which allows the banks to represent their loans at upwardly adjusted prices, thereby providing large improvements to their balance sheets.

It's all very interesting, but what happens if the default rate on those bad loans keeps climbing? People that are unemployed are not going to be able to service their loans. I see a lot of accounting fixes, but so far I don't see any fixes for our economic engine … unless our economic engine is mostly concerned with building speculative bubbles and Ponzi schemes. Is that all there is?

Apr 20 10:47 AM

[John Slater:]

As I previously raised at mergers.com/toughtimes.../, 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 in the form of unsecured debt. In a normal world when a company goes broke some or all of the debtholders' interests 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(us1.institutionalriska...) 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.

Apr 20 11:12 AM

[Warm_Paw:]

These sleight of hand tactics have brought me from mild confusion as to what is occurring to outright knowledge something is very wrong.
Back to the sidelines.

Apr 20 11:24 AM

[Steven Hansen:]

the real question is what is in this for the tax payers. i see the upside for the banks - it seems we will continue to hold the bags of shit.

Apr 20 11:39 AM

[Linus Wilson:]

I think Mr. Kwak is wrong. See seekingalpha.com/artic....

Apr 20 11:40 AM

[Pent up demand:]

"Converting this capital to common equity actually takes the capital OFF the liability side and yet leaves the assets intact."

And not only that, it helps cash flow. The TARP preferred paid 8% I believe.

Apr 20 11:45 AM

[Michael Terry:]

While the conversion does not immediately create value, the reduction of the fixed preferred expense has the ability to create capital by retention (much like cutting the divvie). The bigger issue is then the government ownership of the bank and the far reaching implications of this government ownership (especially when it is extended to other banks as well).

Apr 20 11:57 AM

[Jesusonair:]

It seems that Geithner and Co think that as long as stock markets and bank stocks aren't falling, it's all good. Tricks with accounting and converting preferreds to common and etc - everything will do.
They should rather be worried how to create jobs, but of course, we have to heal our beloved financial buddies first - then the economy will recover. They think that when banks will start to lend like crazy it's all gonna be fine and house prices gonna be on fire again and toxic assets will become the hottest edge of financial innovation again. But wait a second, banks are not lending more
1) because they're f*cked; 2) because we have recession on our hands and people/companies borrow less during downturns.
So with their logic we get out of this vicious cycle, with broken banks leading us through. + The same people who got us into this are in charge of things. So now we have:
Preferred shares = nonsense. Common shares = kickass capital. Toxic assets = diamonds in the rough. DEBT = WEALTH.
Can you believe this is really happening? This isn't some rubbish orwellian "DOUBLETHINK", or CNBC's "GROUPTHINK", no sir.
IT'S FOR REAL. AND IT'S HAPPENING NOW.

Apr 20 12:06 PM

[Moon Kil Woong:]

Great points by the author. The Fed, Administration, and Treasury also think letting banks put money in a side entity to bid up their own assets also helps banks as does pushing FASB to let them lie about their asset values. In each case, these moves do nothing to cover real losses or boost assets or reserves. In fact, they encouage banks to paper over the loss and drop their reserves even more.

It is good to see banks aren't buying their own lies and are boosting their reserves anyway, however, it shows up the profitability and accounting lies. If their assets didn't drop why are they boosting reserves. If their business is so profitable why are they cutting back lending? 1+1 in bank acounting seems to equal + or - whatever you want it to be.

It doesn't take a genius to figure out their is something wrong with their alleged rosy earnings figures. It will be even more apparent as they rush to raise capital on the fictional acounting profits this quarter. Why does a profitable bank dilute its shareholders when it is reaping a good profit? It doesn't.

Apr 20 07:26 PM

[marketman54:]

Existing toxic assets, rising mortgage defaults with increased unemployment, toxic credit default swaps, credit card default payments and toxic commercial real estate - CAN THE METEOR GET ANY BIGGER BEFORE IT HITS THE FINANCIAL MARKETS ?

Folks, I am no genius but I have been wondering why this is all new exciting bad news. I have been posting to these items and wondering why no one has been talking about them and why it has taken the market trading morons to recognize these problems.

Whatever the reason, its time to start shorting this baby and ride it down to 5500, that's right, we will be lucky if it stops there by September!!

Apr 20 09:38 PM

[altaman:]

It is just the Obama two-step: step 1: force the banks to take government money, step 2: covert the debt to equity. Presto chango the US taxpayer is deeply invested in a bunch of insovent banks and on the hook for more and more infusions. This is the worst of all world for US taxpayers and we will be in for a 10 year depression when all the capital is sucked out of the economy to service the new debt via Treasury sales and confiscatory taxes. Socialism/Fascism here we come.

Apr 21 07:16 PM