[OPE] How they are going to turn liabilities into assets, and turn debits into credits, using the state as guarantee or as shareholder: example 1

From: Jurriaan Bendien <adsl675281@telfort.nl>
Date: Wed Apr 29 2009 - 16:37:35 EDT

Fixing bankrupt systems is just the beginning By Martin Wolf FT April 28

( ...) the writedowns estimated by the IMF are equal to 37 years of official
development assistance at its 2008 level. Estimated writedowns on US and
European assets, largely held by institutions located in these regions, also
come to 13 per cent of the aggregate gross domestic product. The IMF
estimates the additional equity requirements of the banks as well. It starts
from total reported writedowns up to the end of 2008, which come to $510bn
in the US, $154bn in the eurozone and $110bn in the UK. The capital raised
to the end of 2008 is, again, $391bn in the US, $243bn in the eurozone and
$110bn in the UK. But the IMF estimates additional writedowns in 2009 and
2010 at $550bn in the US, $750bn in the eurozone and $200bn in the UK.
Against this, it estimates net retained earnings at $300bn in the US, $600bn
in the eurozone and $175bn in the UK. The IMF points out that the ratio of
total common equity to total assets - a measure investors burned by more
sophisticated risk-adjusted ratios increasingly trust - was 3.7 per cent in
the US at the end of 2008, but 2.5 per cent in the eurozone and 2.1 per cent
in the UK. The IMF concludes that the extra equity needed to reduce leverage
to 17 to 1 (or common equity to 6 per cent of total assets) would be $500bn
in the US, $725bn in the eurozone and $250bn in the UK. For a 25 to 1
leverage, the required infusion would be $275bn in the US, $375bn in the
eurozone and $125bn in the UK. In current dire circumstances, the chances of
raising such sums from markets are zero. Part of the reason is that they
could still prove to be too little. After all, the IMF's estimates of the
potential writedowns on US assets alone have grown nearly three-fold in just
one year. It would not be surprising if they rose again. Yet these are not
the only sums required. Governments have so far provided up to $8,900bn in
financing for banks, via lending facilities, asset purchase schemes and
guarantees. But this is less than a third of their financing needs. On the
assumption that deposits grow in line with nominal GDP, the IMF estimates
that the "refinancing gap" of the banks - the rollover of short-term
wholesale funding, plus maturing long-term debt - will rise from $20,700bn
in late 2008 to $25,600bn in late 2011, or a little over 60 per cent of
their total assets.

Fed Is Said to Seek Capital for at Least Six Banks, By Robert Schmidt and
Rebecca Christie, April 29 (Bloomberg)

At least six of the 19 largest U.S. banks require additional capital,
according to preliminary results of government stress tests, people briefed
on the matter said. While some of the lenders may need extra cash injections
from the government, most of the capital is likely to come from converting
preferred shares to common equity, the people said. (...) Along with Bank
of America and New York-based Citigroup, some regional banks are likely to
need additional capital, analysts have said. SunTrust Banks Inc., KeyCorp,
and Regions Financial Corp. are the banks that are most likely to require
additional capital, according to an April 24 analysis by Morgan Stanley.

U.S. May Convert Banks' Bailouts to Equity Share By EDMUND L. ANDREWS NYT
April 19, 2009

White House and Treasury Department officials now say they can stretch what
is left of the $700 billion financial bailout fund further than they had
expected a few months ago, simply by converting the government's existing
loans to the nation's 19 biggest banks into common stock. (...) Treasury
officials estimate that they will have about $135 billion left after they
follow through on all the loans that have already been announced. But the
nation's banks are believed to need far more than that to maintain enough
capital to absorb all their losses from soured mortgages and other loan
defaults. In his budget proposal for next year, Mr. Obama included $250
billion in additional spending to prop up the financial system. Because of
the way the government accounts for such spending, the budget actually
indicated that Mr. Obama might ask Congress for as much as $750 billion.
(...) 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.

Bit of criticism:

Common stock no longer pays a dividend at most TARP banks, and if the bank
fails or needs more capital, the common stock gets hit first. One positive
aspect of this plan is that it won't require the US government to borrow any
more money to fix the banking system. If the banks can actually be turned
around, moreover, it might eventually lead to--gasp--profit for the
taxpayer, when the stakes are eventually sold. But the government should be
converting bondholders' stakes to equity, not taxpayers' stakes. (...) what
is being proposed here is not the conversion of debt to equity but the
conversion of taxpayers' preferred stock to equity. In other words, in the
interests of protecting private-market bondholders to the tune of 100 cents
on the dollar, taxpayers may, yet again, likely take it on the chin. The key
metric in such transactions is the conversion ratio: The number of common
shares the taxpayer gets for each preferred share. If Tim Geithner's goal
here is to give the banks another gift at taxpayer expense, he'll do it
through the conversion ratio.

Bit of explanation:

A capital adequacy ratio is the ratio between some measure of capital to
total assets. Imagine for a moment that there was only one kind of debt -
say, deposits - and one kind of capital - ordinary shares. Say my bank has
$100 in assets. As we all know, assets can go up or down in value. If I have
$90 in debt, then I have $10 in capital, and my ratio is 10%. This means
that my assets could fall in value by up to 10% and I would still be able to
pay back my depositors. If, instead, I have $99 in debt, then my ratio is
only 1%. If my assets fall by more than 1% in value, I won't be able to pay
back my depositors, I'll be insolvent, and the FDIC will take me over so it
can pay off the deposit guarantees at minimum risk to itself. This is why
the capital adequacy ratio matters, especially to bank regulators. (...) One
commonly used measure of capital is called Tier 1 Capital, which includes
common shares, preferred shares, and deferred tax assets. A less commonly
used measure is Tangible Common Equity (TCE), which includes only common
shares. Obviously, TCE will yield a lower percentage than Tier 1. (...) One
difference between the two is whether you count preferred shares as
liabilities, which depends on how bad you think it is that preferred
shareholders don't get their money back. Another difference depends on what
you think the deferred tax credits are worth in a worst-case scenario. In
any case, the skeptics, like Friedman Billings Ramsey, have been insisting
since the beginning of the crisis that TCE is the proper measure of bank
solvency. And most immediately, Tim Geithner has said that the new bank
stress tests will focus on TCE. (...) The initial government investments in
Citigroup, back in October and November, were in the form of preferred
shares. Between the two bailouts, the government put in $45 billion in cash
and got $52 billion in preferred stock (the $7 billion difference was the
fee for the guarantee on $300 billion of Citi assets). That preferred stock
was designed to be much closer to debt than to equity: it pays a dividend
(5% or 8%), it cannot be converted into common stock (so it cannot dilute
the existing shareholders), it has no voting rights, and it carries a
penalty if it isn't bought back within five years. In fact, it is hard to
distinguish from debt, except perhaps for the fact that, if Citi defaults on
it (cannot buy the shares back) we don't need to worry about systemic
instability, because the government can absorb the loss. As preferred stock,
these bailouts boosted Citi's Tier 1 capital, but not its TCE. Because of
the newly perceived need for TCE, the bailout plan under discussion is to
convert some of the preferred stock into common stock. Citi wouldn't
actually get any new cash from the government, but it would be relieved some
of the dividend payments (currently close to $3 billion per year), and of
the obligation to buy back the shares in five years. (...) This is a real
benefit to the bank's bottom line, and hence to the common shareholders. At
the same time, though, Citi would issue new common shares to the government,
diluting the existing common shareholders (meaning that they now own a
smaller percentage of the bank than before). In theory, the amount by which
the shareholders in aggregate are better off should balance the amount of
dilution to the existing shareholders. The trick is deciding what price to
convert the shares at. All of Citi's common shares today are worth around
$12 billion, so if you converted $52 billion of preferred shares into
common, the government would suddenly own over 80% of Citi. (In the
conversion, you divide the value of the preferred stock you are converting
by the price of the common stock, and that yields the number of common
shares the government now owns.) The Geithner team is still continuing the
Paulson policy of avoiding anything that looks like nationalization, so the
talk is that the government ownership will be capped at 40%; that means the
government could only convert about $8 billion of its preferred stock. There
will probably be some clever manipulation of the numbers to say that the
preferred stock is actually worth less than $52 billion, or that it should
be converted at a higher price than the current market price of the stock.
(This seems like a blatant subsidy to me, since new investors buying large
blocks of stock in a public company typically pay less than the current
market price.) There is also talk of trying to get some of Citi's other
preferred stock holders to convert as well, because the more they convert,
the more common shares, and hence the more the government can have without
going over the 40% limit.

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Received on Wed Apr 29 16:44:47 2009

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