There's a new wrinkle in the latest round of recapitalizations: The only way for the banks involved to win is for taxpayers to lose.

This was revealed in deals announced this week to shore up the balance sheets of two companies that have warned of their possible demise. Though each deal has multiple strings attached, there is a common thread — the investments hinge on the Treasury Department's converting its preferred shares into common equity at a steep discount.

Experts said that up until now they were unaware of any previous instance in which the department was willing to take a hit in the conversion of preferred shares it was issued under the Troubled Asset Relief Program. But it has agreed to do so in one of the cases, a bank involved said late Thursday.

"Treasury has to make a valid business decision. They made an investment, and we all know that, in investing, you don't win them all," said Walter G. Moeling 4th, a partner in the law firm Bryan Cave LLP in Atlanta. "As a taxpayer, I'd much rather get something than nothing."

Late Thursday, the $10.5 billion-asset Sterling Financial Corp. in Spokane, Wash., announced that the Treasury agreed to take a 75% haircut on its $303 million Tarp investment, accepting $75.8 million of common equity. That led the company to enter into a definitive agreement with Thomas H. Lee Partners LP, a Boston private-equity firm, to invest $135 million in Sterling. However, both agreements call for the company to raise an additional $585 million in common equity.

Similarly, on Thursday, the $7.3 billion-asset Pacific Capital Bancorp in Santa Barbara, Calif., announced that a unit of Ford Financial Fund LP, an entity controlled by veteran bank investor Gerald J. Ford, had agreed to pump $500 million into the struggling company. The deal calls for the Treasury to convert its $180 million Tarp investment into $36 million worth of common stock, an 80% discount.

In conference calls with investors this week, executives said the pledged investments are essential to their survival.

"This provides us with firm footing for the future," George Leis, the president and chief executive of Pacific Capital, said in a conference call Thursday. Greg Seibly, Sterling's president and chief executive, made similar remarks about the potential investment in his company.

Both companies have been rocked with credit-quality issues and were out of compliance with enforcement orders imposed by their primary federal regulators. Both also warned in filings with the Securities and Exchange Commission this year that serious doubt existed about their viability.

Given this predicament, experts said, it was not surprising that the recapitalization deals were accompanied by significant strings that would require existing stakeholders to take a hit. Both deals, according to analysts, are highly dilutive to existing common shareholders. Also, Pacific Capital's deal calls for holders of trust-preferred securities and subordinated debt to take 80% and 70% discounts, respectively, through cash offers.

Ford's investment in Pacific Capital also would require the company to commence a rights offering to existing common shareholders after the deal's closing so that they might recoup some of the value they would lose through dilution.

"We look forward to helping strengthen this institution for the benefit of all its stakeholders," Ford said in the company's press release Thursday.

For investors in troubled institutions, requiring the other stakeholders to accept such discounts is the only way to make the numbers work, said Steve Hovde, a longtime bank investor and president of Hovde Financial.

"New money does not want to enter without the other shareholders' taking a discount," Hovde said in an interview. "New money doesn't want to bail out the existing base by making them whole."

Shareholders are left to weigh their options. They can take the discount or risk that the company's capital hole will widen and that its bank could fail.

Lawrence Kaplan, a partner in Paul, Hastings, Janofsky & Walker LLP, said the Treasury must seriously consider whether such an offer is the company's last hope. "They could have zero, or they could have something," he said.

Such deals probably will become more common, he said.

"It's going to be interesting to watch what they do because this is going to set a precedent," Kaplan said, adding that other investors could become even more aggressive in discount offers.

Kip Weissman, a partner in the Luse Gorman Pomerenk & Schick law firm, said such announcements are rarely made without some prior indication of Treasury's willingness to take a hit. "There's no way they would sign this if they hadn't had extensive discussions with Treasury," he said. "Otherwise, it would be nuts."

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