Though the common stock of many banking companies has enjoyed a cautious revival, other funding instruments are getting hammered as investors factor in default risk.

Concerns are mounting that the government could arm-twist preferred shareholders and bondholders to convert their holdings to common stock to shore up tangible common equity.

"At one time you never would have thought about a solvent institution reneging on debt, but you can now," said Michael Knebel, a portfolio manager for debt at Ferguson Wellman Capital Management in Portland, Ore. "Now you can discount debt on that risk."

The Treasury Department's stress tests are adding to the pressure. The results are scheduled to be released to the public next week. (See related story.)

"The pricing right now reflects the anxieties that bank investors have about financial institutions," said Scott Sprinzen, a credit analyst at Standard & Poor's Corp., who views those fears as "overplayed."

Though first-quarter results largely beat Wall Street expectations, "this is a time in the cycle where the pricing clearly doesn't line up well" with the results, he said.

Observers are drawing distinctions between different types of debt instruments. The most susceptible is preferred stock, which is already causing headaches for the industry and common shareholders. The 10 biggest banking companies paid preferred investors $4.29 billion of dividends in the first quarter, either reducing earnings or taking results into the red.

Those dividends are at risk as talk intensifies about converting preferred shares to common ones, many of which are paying nominal dividends.

Citigroup Inc. and Huntington Bancshares Inc. have stated an intention to convert preferred shares, and analysts have speculated that others, such as Bank of America Corp. or Fifth Third Bancorp, may need to follow suit in the wake of the stress tests.

The preferred shares of many big banking companies are trading well off their 52-week highs.

Several classes of B of A preferred stock are off 50% from where they peaked last year. In addition, such concerns have become tricky for bankers, and in some instances auditors are requiring banks to value preferred stock at a discount.

A director for a small Kentucky bank said its auditor recently required it to book its preferred stock at a cost of 13%, compared with its dividend yield of 5%. "I was flabbergasted at the rate," said the director, who asked not to be named. "It made the preferred stock appear more expensive and even riskier than the common. It takes back any advantage you had from the low cost of capital" associated with the issuance.

Observers say certain tranches of debt could face similar pressure. Senior debt with shorter maturity periods is holding up relatively well; observers credit the Temporary Liquidity Guarantee Program for the buoyancy, even for bonds not covered by the Federal Deposit Insurance Corp. program. Longer-duration subordinated debt has fared far worse, over concerns that those bondholders might be the first to be asked to convert.

Citi has a senior tranche due in 2011 that is pricing at about 97% of par, while a subordinated tranche due in 2032 is being bid at 59%, according to Bloomberg. B of A and, to a lesser degree, JPMorgan Chase & Co. were experiencing similar trends with certain debt issuances.

Steven Sandler, the chief executive of Crosswind Capital LLC, said all senior debt would be under the same pressure as subordinated debt if the FDIC no longer offered the guarantee program.

"At the end of the day, what is supporting the senior stack isn't earnings or assets," Sandler said. "It is the implicit guarantee. Absent that, there would be more of a focus on strict liquidation value for these bonds, and there would be a real risk of a near-term receivership."

Though the Obama administration has given no indication that it would try to force bondholders to convert, House Financial Services Committee Chairman Barney Frank has suggested that such investors take a "haircut" to shore up the system. "Risk is inherent in the nature of being a bondholder," Frank told Financial Times last week, in particular singling out those who hold subordinated debt.

Not everyone is convinced that debt conversions are going to happen, at least on a large scale.

Sean Jones, an analyst Moody's Investors Service Inc., wrote in a report issued last month that such a scenario is "unlikely." In his view, "such actions would run counter to the overall policy objectives" supporting the industry. "Having said this, risks to bondholders do indeed increase for lower-priority capital instruments and for those that hold the debt of weaker banks that are less important to the nation's financial system."

In contrast, Christopher Whalen, the managing director at Lord, Whalen LLC's Institutional Risk Analytics, said some banking companies could end up pressuring bondholders to convert. "Ultimately, I believe the successful banks will be those that can turn to their bondholders and ask for an unequivocal statement of support" in the form of conversion. "If you want a market resolution, the deepest pockets right now are the bondholders," Whalen said.

Bankers could eye partial debt conversions, perhaps looking to convert bonds in 10% increments until credit and liquidity pressures subside, he said.

It is unclear when those pressures will abate or when the financial system will return to some form of normalcy.

"There has been a shift in risk premium and the days of single-digit credit spreads on debt are over," Whalen said.

Sprinzen held out more optimism. "We would expect pricing to better reflect underlying fundamentals as those fundamentals improve," he said. "That could be another year or two — maybe more."

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