Last Thursday the US Treasury agreed to convert $25 billion of TARP Series H Preferred Stock into common equity at an exchange price of $3.25 per share.  The stated goal of this exchange was to increase the bank’s Tangible Common Equity and thus ensure more investor confidence in the institution’s long-term prospects.  This transaction is nothing but an accounting shell game which doesn’t inject new funds into the institution but simply reorders the priority of claimants in the event the institution should fail.  Specifically, it moves both the taxpayer and other preferred shareholders who accepted conversion of their private preferred stock to common equity into a first-lost position.  While giving the taxpayer a larger ownership share, the transaction also increases taxpayer risk exposure and removes the promised dividend payment that the preferred stock carried. 

Recently, policy makers appear for some unexplained reason to have become obsessed with Tangible Common Equity (TCE) as the appropriate measure of a firm’s capital adequacy, when traditionally banking supervisors have focused on Tier I and Tier II capital.  The FDIC, for example, defines Tier I capital as including not only common equity (TCE), but also noncumulative perpetual preferred stock, surplus, and retained earnings.  Minor adjustments may be made to recognize losses and certain other disallowed items.  Tier II capital includes qualified subordinated debt and redeemable preferred stock, cumulative perpetual preferred stock, allowances for loan and lease losses, and unrealized gains on certain Available-For-Sale Equity Securities.  Tier I and Tier II components are the main building blocks in the supervisors’ approaches to assessing capital adequacy. 

Conceptually, these capital components are to provide a buffer to absorb losses should adverse risks materialize.  Loss protection to creditors is provided by deposit insurance (now at $250K per insured account) for insured depositors, but more recently the US government has extended guarantees to certain debt issues, as well as against losses on assets.  For example, the FDIC last fall was granted authority to temporarily guarantee all newly issued senior unsecured debt issued by Eligible Entities on or before June 30, 2009, for three years beyond that date.  This includes promissory notes, commercial paper, interbank funding, and any unsecured portion of secured debt.  Also covered were funds in non-interest-bearing transaction deposit accounts held in FDIC-insured banks until December 31, 2009.  In Citigroup’s case, the government has gone even further in its effort to protect that company.  The Treasury, FDIC, and Fed together have arranged to guarantee about $301 billion of its assets against loss. 

All these arrangements significantly complicate the sorting out of who is covered and what assets are actually available (that haven’t otherwise been pledged as collateral) to protect general creditors.  In the end, there are really only two types of bank creditors: those that hold insured or otherwise guaranteed liabilities and those that don’t.  The chief difference among the “don’ts” is where they stand in line when losses are parceled out.  What the Treasury has done is simply changed some other preferred stockholders’ and the taxpayers’ place in line, while providing a small subsidy in terms of forgiving interest of about $ 1.5 billion in yearly savings in preferred stock dividends, which is about 4% of Citi’s current interest expense.  But nothing was done to identify or sort out embedded losses in Citigroup’s portfolio, nor was the cushion increased to absorb those losses. Looking ahead at what this transactions means, clearly there is more uncertainty for banks, especially for the top 19 who are about to go through their stress tests. We don’t know what the stress tests will reveal or how they will be handled. But Chairman Bernanke said in his testimony last week that the intent is not to conduct a pass/fail test.  So what will the regulators do if the need for more capital is determined?  If an investor thinks that a bank might be forced to take a government equity capital injection, for example, then there would be certain dilution and reductions in the value of any outstanding preferred stock.  Given this, it is not clear how or why investor confidence should be improved.