Friday, February 27, 2009

Stress test semantics and the fight to stave off the N-word!

The request by Citigroup for additional capital which would raise the government stakes from the present 8% to about 40%, and also the conversion of the non-voting preferred share stake of government into common stock, has triggered off a debate about the exact nature of how government capital infusions should be classified. The always incisive James Kwak sets the stage superbly here, and goes right at the heart of the matter - define capital in a manner that the "zombie banks" can somehow be continue to be propped up with capital infusions till the markets get back to normal!

As Kwak explains, capital can span the whole spectrum from common stock to preferred stock to deferred tax assets (credits you gain by losing money in one year, which you can apply against taxes in future years where you make money). Whereas Tier 1 capital includes all the three, Tangible Common Equity (TCE) consists of only common stock. Since the latter is smaller than the former, the capital adequacy ratios calculated using the latter is smaller.

The stress tests will seek to evaluate the strength of banks based on among other things, their capital adequacy ratios. Capital adequacy (ratio of capital or equity to the total assets) measures the "ability of the bank to withstand losses before its ability to pay off its liabilities starts getting compromised" or how much "my assets could fall in value by upto and still I would be able to pay back my depositors". Regulatory requirements specify certain minimum standards for capital adequacy ratios. The Treasury Secretary has declared that the stress tests being dones as part of TARP II will assume TCE as capital. This raises interesting challenges for those receiving bailout money in the form of preferred shares, as the Citi's predicament shows.

The government has so far put into Citi $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). The 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.

The present interest in converting the preferred stock stake of the government into common stock stems from a need to boost the TCE, and thererby increase the capital adequacy ratio to meet the minimum standard. Further, it would relieve Citi from the close to $3 bn per year dividend payouts and the the obligation to buy-back the preferred shares in five years. All this would benefit the bank’s bottom line, and hence its common shareholders, even with the attendant dilution of stakes as the government stake squeezes the existing owners. But with the current market capitalization of Citi's shares at just $12 bn, a conversion of all of the $53 bn government preferred shares to common stock would leave the government holding 80% of Citi! As Kwak explains, any purchase at higher than the market price, would be a straight subsidy to the existing shareholders.

However, as Kwak argues, the more important issue for consideration may not be the minutiae about how the government stake should be classified or which measure of capital should be considered, but how the government can manage its stake with management control but without controlling day-to-day operations, while at the same time ensuring that tax-payers money is most efficiently deployed. And the experience with AIG, where government owns 80%, shows how the government ends up with the worst of both worlds by dilly-dallying on the crucial aforementioned issues.

Or more preferably when faced with a banks with more liabilities (debt) than all capital (Tier I), as Paul Krugman says - seize the bak, clean out stockholders, pay off some of the debt, and re-privatize the entity - same as FDIC receivership or nationalization!

There is one another thing which lends credence to the view that these semantic quibbles may be irrelavant. The Modigliani Miller theorem claims that under certain conditions, it does not matter if the firm's capital is raised by issuing stock or selling debt, or what the firm's dividend policy is. All these debates about the exact nature of government stakes also assume (or hope) that the share prices will rebound once normalcy is restored to the markets, so that government can exit without too much cost to the tax payer. So the issue at hand is to get the normalcy restored by getting confidence back in the banks and thereby stem the decline in asset values, and not debating capital structure!

One cannot but help concluding that in the final analysis, all this gymnastics about conversion of preferred shares and stress test details is an exercise in avoiding nationalization and continue propping up zombie banks. Ben Bernanke, (full text here) in his testimony before the Senate two days back, had ruled out nationalization or anything where "the government seizes the bank and zeros out its shareholders". Simon Johnson and James Kwak sums up the context in light of Ben Bernanke's ambiguous and hope-filled testimony and the confusion surrounding the bailout dynamics,

"This is another sign of the serious brainpower that has been expended on finding ways to avoid or minimise government ownership of banks, and to avoid the slightest possibility of offending shareholders – shareholders whose shares have positive value primarily because of the expectation of a further government bail-out.

The government's percentage ownership of a bank is a red herring. The key economic realities are: the government is already responsible for a large portion of bank liabilities, through insurance on deposits and new bank debt; the government is the only source of new capital for banks; and the government stress tests will determine whether banks are allowed to continue in operation and under what terms. The only purpose served by artificially minimising government "ownership" is to limit the potential upside available to taxpayers."

Adam Posen (and here) sets the historical context by drawing parallels with the Japanese lost decade,

"The guarantees that the US government has already extended to the banks in the last year, and the insufficient (though large) capital injections without government control or adequate conditionality also already given under TARP, closely mimic those given by the Japanese government in the mid-1990s to keep their major banks open without having to recognize specific failures and losses. The result then, and the emerging result now, is that the banks’ top management simply burns through that cash, socializing the losses for the taxpayer, grabbing any rare gains for management payouts or shareholder dividends, and ending up still undercapitalized. Pretending that distressed assets are worth more than they actually are today for regulatory purposes persuades no one besides the regulators, and just gives the banks more taxpayer money to spend down, and more time to impose a credit crunch."

Update 1
Economix has a nice sum up of the stress test scenarios here, and the "more adverse" case scenario is by no means as bad as being predicted by many. Does this mean that the stress tests will let off many banks lightly and then see them come back repeatedly for more assistance?

Update 2
NYT reports that the Treasury is considering conversion of the government’s existing loans to the nation’s 19 biggest banks into common stock, and give the government a large ownership stake in return. Paul Krugman and James Kwak feel that this conversion is only a "swap among the junior stuff, with no impact further up the line". And an analogy on the conversion here.

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