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Throughout the year, asset prices of pretty much everything in the financial markets have surged ahead, making 2009 a windfall year in trading profits for banks. As the next decade gets underway, the challenge for many financial institutions is going to be in figuring out the definition of fair value — of their own stock, and in turn for everything they hold.

Wednesday, Bank of America (BAC) stated that it will be ready to buyback $45 billion of its preferred stock which is currently held by Treasury. It plans to do so by taking a fourth-quarter charge of $4.21 billion, and by raising a whopping $18.8 billion in cash from the sale of common stock. (Effectively, the deal is a less tightly-executed version of a recent Zions Bancorporation (ZION) transaction, where shareholders agreed with the firm to swap preferred stock for common stock, in anticipation of big rises in the latter in the future.)

Citigroup (C) is currently no nearer to paying its TARP funds back than it was last quarter, but that doesn’t mean that things won’t change soon for the bank. In fact, analysts think Citi may be spurred by Bank of America to take action sooner rather than later.

As fate would have it, just as Abu Dhabi’s commercial banks have been wrestling with the default of Dubai World Ports (you can read the story here), the state now finds itself on the hook for Citi stock priced at $31.83 a share. Abu Dhabi agreed to convert at the super-high strike price back in November 2007, when presumably it thought that most of the financial crisis had already been washed through the system.

The deal will force Abu Dhabi to pay roughly 7 times over today’s market value for Citi stock, and will boost the bank’s common equity by around $1.9 billion. It is likely that Citigroup will use at least some of the funds to buy-back its preferred stock which is currently held by Treasury.

Deleveraging, revisited

The reason both banks’ valuations have soared so much this year is because of their status as leveraged investments via Treasury’s massive lending program. With everything leveraged in the current climate, it’s fairly easy to put a price on the numerous assets the banks hold, such as stocks, derivatives and even real estate. Once the leverage dries up — in other words, once the banks hand back the money they owe the taxpayer — values will have to readjust to the new debt-free landscape.

The concept of fair value is less academic than it sounds. After all, the whole reason for the massive writedowns many banks were forced to endure for nearly two years up until the beginning of the first quarter was because of, in part, gross miscalculations of the assets they were holding.

The big problem is not so much for the banks that will avail themselves of government funding soon, but rather for the numerous small and medium-sized banks that will still have debt on their books, while having to resize their portfolios and their growth prospects going forward.

Historically, the numbers prove this point is a much bigger deal than many may be aware. Prior to June 19, when Goldman Sachs (GS), JP Morgan (JPM) and seven other big banks repaid their TARP loans, just 37 U.S. banks had shuttered their doors. Since that event, the number of bank closures has surged more than two-and-a-half times, to a total of 87, according to official data from the Federal Deposit Insurance Corporation.

Those who are impatient to see an end to government bailout packages ought to be careful about what they wish for.

Source: Majority of U.S. Banks May Suffer as Citi, Bank of America Near TARP Payback