Posted by: Tobias | October 17, 2008

Recapitalization strategies

Adam Levitin of Credit Slips on why the US Treasury may be buying preferred stock in banks rather than common stock (like the British) to recapitalize them:

The important thing to notice about the Treasury's "equity" injection into major financial institutions is that it is equity in name only. The preferred stock the Treasury is taking is at a prescribed dividend (5% for 5 years, 9% thereafter) and has no voting rights. Economically, it is a subordinated loan without a term.

A few observations come out of this. First, is that it means that Treasury has very little economic upside. No matter how well the banks perform, the best that Treasury can do is get a 5% return. True, the Treasury will get warrants for common stock, which gives it some upside, but that is only for around 13% of the deal; the other 87% of the deal has no upside. Also, Warren Buffet was able to get 10% from Goldman Sachs. Why isn't Treasury getting the same deal? (And how fast do you think Goldman will use 5% Treasury dollars to buy back Buffett's 10% stock, if he doesn't have redemption restrictions in the deal?)

Second, by making an economic loan, but doing it in the form of preferred stock, Treasury has functionally subordinated itself to the bondholders and other debt obligations of the banks. That is a HUGE boon for the bondholders, because it functions a lot like a government guarantee of their positions. It also benefits the common shareholders by making sure that they won't be taken to the cleaners like WaMu and Lehman shareholders.

Third, as has been noted elsewhere, Treasury didn't forbid the financial institutions from paying dividends on the common stock, only from raising the dividends. So formerly cash strapped institutions are going to be able to keep paying out dividends…from taxpayer funds.

So why did Treasury do the deal as preferred stock?

My guess is that it mainly had to do with bank capital requirements. Both banks and bank holding companies have complex capital adequacy requirements. If violated, various regulatory sanctions are triggered.

Why would the difference matter, you may ask? Felix Salmon explains:

If you’re running an insolvent bank, and you get a slug of equity from Treasury, your shareholders will thank you if you use that equity to take some very large risks. If they pay off and you make lots of money, then their shares are really worth something; if they fail and you lose even more money, well, there was never really any money for them to begin with anyway.

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Responses

  1. As you know, I am not really into finance all that much, but might one reason for buying the preferred stock not simply be that the Treasury wants to keep these banks as independent as possible from political influence.
    After all, if the Treasury had voting rights for all of the shares it owns, the government might be tempted to exert an influence on the banks going beyond what is needed just to save these banks from bankruptcy.

  2. I’d be the last person to underestimate the dangers of political meddling in private-sector institutions (why does it seem funny to write these words concerning banks these days?), but handing out this money and not having any influence about how it will be employed seems like setting up rather bad incentives.


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