WASHINGTON — Another week, another new plan to stabilize the banking industry.
But the latest one — converting government-held preferred stakes in banks into common equity — seems to have backfired as critics cited legal and practical obstacles and shares of financial services companies plummeted on the news.
"We should have a moratorium on clever new schemes by the week," said Amar Bhide, a professor of finance at Columbia University.
If the Treasury Department follows through on the idea — still a big if at this stage — it could create conflict of interest issues, raise questions about the validity of regulatory capital standards and put the government at greater risk for losses, observers said.
It was unclear how serious the Treasury is about the idea, which was reported first in The New York Times in what appeared to be a trial balloon.
In theory, the move is meant to boost banks' tangible common equity ratios, reduce their dividend obligations and give the government greater control over institutions.
Of those arguments, relieving banks of their dividend obligations may be the most powerful, observers said. Banks currently pay a 5% dividend to the government on their preferred shares but would not have to do so if it was converted to common.
"If you convert $25 billion of preferred stock carrying a dividend of 5% to common stock, you just saved that bank $1.25 billion of dividends a year," said Kip Weissman, a partner at Luse Gorman Pomerenk & Schick PC.
But the flip side is obvious: The government in effect takes on added risk because it gives up the right to a guaranteed 5% return.
"You've changed the financial institutions' recapitalization, which is 'stronger' because it doesn't have to pay out the preferred dividends," said Karen Shaw Petrou, managing director of Federal Financial Analytics. "But the government position is weaker."
Raising a bank's tangible common equity ratio is also of dubious value, observers said. Analysts have increasingly turned against regulatory capital requirements as an accurate gauge of banks' capital position and put more faith in TCE.
Converting to common equity would improve banks' TCE ratios, observers said, but only solidify their capital positions if investors continue to have faith in the ratio.
"In a sense, they're gaming the analysts because the analysts have made this assumption that TCE is what matters — well, then Treasury's going to shift its positions around to make the TCE look stronger," said Chris Low, the chief economist at First Horizon National Corp.'s FTN Financial.
Some analysts hailed such a move, arguing that TCE is "real" capital.
"It helps the banks because it gives them true capital," said Paul Miller, an analyst at Friedman, Billings, Ramsey & Co.
But Shaw Petrou, though calling TCE a useful measure, dismissed the idea that it more accurate represents an institution's health.
"Washington Mutual had a very high TCE ratio the day it failed," she said.
If regulators decide to emphasize TCE over regulatory capital standards, some said, it also undermines the current standards.
Converting to common stock also raises problems including the fact that Treasury and the regulators have no legal authority to compel the change. So far, only Citigroup Inc. has voluntarily agreed to convert its government stake to common stock — a move that dilutes current shareholders and gives the government more corporate governance clout.
Regulators could, of course, in effect force a conversion by applying pressure to an institution until it agrees. Kenneth Lewis, the chief executive of Bank of America Corp., appeared to acknowledge as much in a conference call Monday when he said the decision lay with the government, not his board.
"This is in the hands of the regulators," he said.
But any conversion also raises conflict of interest questions for the government, observers said.
"As a minority equity holder, does the government have a fiduciary duty to maximize the value of the bank's equity by harming competing banks where the government does not have an equity interest?" Bhide asked.
Douglas Landy, a partner in Allen & Overy LLP and a former lawyer at the Federal Reserve Bank of New York, said the government could feel pressure to sell the equity stakes back to the banks if the stock market recovers.
"If the shares, say, triple in value, won't there be public pressure for them to monetize the stake?" he said. "And if the shares, say, drop two-thirds in value, won't there be public questioning of 'why did you take this stake?' "
Getting out of a common holding could be harder, observers said. "It would have a dramatic impact on capital markets because you'd have the government being a major seller in common stock in a few years," said the lawyer Weissman.
L. William Seidman, a former chairman of the Federal Deposit Insurance Corp., said, "If you have the government as a partner in a way that you can't get rid of them … long term, that could be a problem."
Finally, it was unclear whether the plan would accomplish what the Times said was the Treasury's ultimate goal: finding a way to bolster banks without asking Congress for additional Troubled Asset Relief program funds.
A stock conversion does not require additional money, and if investors and Wall Street accept it as a beneficial move, it might let the government stretch its existing contributions to banks into something more effective, supporters argued.
"The last thing you want to do in this politically charged environment is run up to the Hill and say you need more money pumped into banks," said Kevin Jaques, a professor and the chairman of the finance department at Baldwin-Wallace College in Berea, Ohio, and a former Office of the Comptroller of the Currency official.
But many in the industry saw it as a gamble. There was no guarantee that conversions would settle the market, and the dilution of existing stockholders could do the opposite. It also gives up a guaranteed form of income in the dividends for preferred shares, many said.
"It's like a hand going against you, and they keep doubling down," said one industry source.
Brian Gardner, a vice president at KBW Inc.'s Keefe, Bruyette and Woods Inc., said, "There's no guarantee that [the banks] won't need more money."
"This buys the government more time, but it doesn't preclude that the government will need to provide the bank more money in the future," he said. "There's still the risk they could continue to lose money, and the taxpayers would be on the hook for that."