No community banking companies have gotten a green light from the Treasury Department to convert its preferred shares to common ones, and few have even bothered trying. But Midwest Banc Holdings Inc. is the second company in less than a week to suggest there could be some government relief forthcoming for those that received funds through the Troubled Asset Relief Program, but are now struggling.

In fact, Midwest, of Melrose Park, Ill., says its chances of getting approval look good.

Whether a conversion will ultimately happen for Midwest or the other hopeful, Anchor BanCorp Wisconsin in Madison, is unclear, industry observers say. Big hurdles remain for both.

The two companies had a negative tangible common equity ratio at the end of the third quarter, and their survival is widely believed to depend on getting the Treasury's cooperation to boost this ratio. But in their favor, the companies have lined up private capital as a buffer, to help get the Treasury more comfortable with the proposal, several industry lawyers and analysts said.

The government would be smart to work with such strugglers, despite some of the issues that could arise from doing so, these observers generally agreed. The taxpayers are already on the hook through the initial Tarp infusion, which could get wiped out by a bank failure otherwise.

"The reason the government invested in banks in the first place was to keep them going, but they balance that with trying to get out as soon as they can," said Oliver Ireland, a partner at Morrison & Foerster and a former Federal Reserve lawyer. "Converting their shares takes them deeper rather than heading out, but if it keeps the bank going, I suppose you convert."

The Treasury declined to discuss the issue. It has already let some Tarp strugglers fail, including UCBH Holdings Inc.'s $13 billion-asset United Commercial Bank, which had $298million in government capital.

But the $3.5 billion-asset Midwest said in a press release last week that it was in "advanced" discussions with the Treasury about its capital plans — which include the potential for a $190 million infusion from private investors — and that it had received a letter indicating the agency's willingness to consent to a conversion.

One condition imposed by the Treasury is that Midwest also convert preferred shares owned by other investors into common ones. An exchange offer is now under way.

The $4.6 billion-asset Anchor announced last week that it has a deal for a $400 million capital infusion from a private-equity firm, Badger Capital LLC, of Inverness, Ill. But the infusion depends on Treasury's agreeing to convert its $116 million investment into common shares.

Both Midwest and Anchor said their capital plans would get their tangible common equity to a healthy level.

Frederick Cannon, co-director of research at KBW Inc.'s Keefe, Bruyette & Woods Inc., said in an interview that he believes any conversion the Treasury approves would have to be in the context of a larger capital plan.

"I don't think we will see the Treasury converting as a last-ditch effort to help save a bank. There would be no real point," Cannon said. "The conversion would have to be one component of an overall plan."

That plan, Cannon said, likely would have to include management changes, too. The boards of both Anchor and Midwest have replaced their chief executives in the past year.

Should either company succeed in winning over Treasury officials, other Tarp recipients could pursue conversions, Cannon said.

Kevin Jacques, a finance professor at Baldwin-Wallace College and a former Treasury official, said that such success also could attract more private capital to the banking sector.

"I think the financial market and private capital would view this as very positive," Jacques said. "The Tarp money is already in there; it would just be converting the form. And in the process it would allow private capital to flow in. This is seriously something Treasury needs to consider."

Jacques said the Treasury could catch flak for extending more help to ailing Tarp recipients, but not nearly as much flak as it would if many more of them failed.

Walter G. Moeling 4th, a partner at the law firm Bryan Cave LLP, said he thinks the Treasury's willingness to consider conversions could end up prompting other forms of government assistance.

Since Midwest and Anchor are in such dire condition, the Treasury's help could be viewed as open-bank assistance, Moeling said. The Federal Deposit Insurance Corp. has repeatedly ruled out such assistance for failing banks, because the law requires all shareholders to be wiped out when this option is used. But maybe it would reconsider.

"Sure, this is the Treasury and not the FDIC, but I think it could put more pressure on the FDIC to look into it," Moeling said. "This certainly looks like a bit of open-bank assistance. This could spur different policy perspectives."

Others disagreed and called that an unlikely consequence. The FDIC did not comment on the matter before press time.

Midwest said in October that it had applied to convert its $84.8 million of government capital into common stock through the Capital Assistance Program.

The Treasury created the program in February, to facilitate such conversions, but closed it last month without making a single investment.

In a Securities and Exchange Commission filing, Midwest acknowledged that CAP had been discontinued but said that it was still pursuing a conversion.

The company declined to comment for this story.

Anchor said that it missed the Nov. 9 deadline to apply for CAP but that the Treasury has the authority to convert its shares under Tarp anyway.

Chris Bauer, Anchor's president and chief executive, said in an interview last week that he was hopeful about getting approval. He said a conversion would benefit the Treasury by enabling the agency to liquidate its shares more easily.

Several observers said the Treasury likely would tie additional strings to a conversion. Cannon said in his note that the Treasury could seek better conversion terms, impose additional operating restrictions or add tougher pay limits.

Moeling said he hopes the agency does just that.

"I see this as a real positive, but I hope as a taxpayer that the Treasury negotiates very hard," Moeling said. "All the parties might need for this to work out, but that doesn't mean the Treasury should roll over and play dead. And I suspect that they won't."

Moeling added that the first round of Tarp funds, doled out a year ago, set a precedent for the Treasury's willingness to work with companies that obtain additional capital from the private sector. For example, the $14.8 billion-asset Flagstar Bancorp Inc. in Troy, Mich., received Tarp only after raising outside capital. Flagstar received $250 million from the New York private-equity firm MatlinPatterson Global Advisors LLC. In the past year MatlinPatterson has increased that investment by an additional $100 million.

"This would be consistent with what they've done all year," Moeling said of Treasury officials. "To get Tarp, you either had to prove you were viable without it or you could raise some money elsewhere."

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