Midwest Banc Holdings Inc. has won another round in its battle for recapitalization, as a result of an unusual move by the Treasury Department.

Midwest, of Melrose Park, Ill., announced late Tuesday that the Treasury had agreed to convert $84.8 million of preferred shares it bought in December 2008 under the Troubled Asset Relief Program, along with $4.5 million of unpaid dividends, into $89.3 million in shares that would become common equity. But first the Treasury is requiring the $3.4 billion-asset Midwest to raise an additional $125 million from private investors.

Though the conversion alone would not resolve the severe capital problems of Midwest's undercapitalized bank unit, industry observers said the agency's decision could bode well for other banks that received Tarp funds and are still fighting for survival.

"I think we are going to see more of these as Treasury begins to play ball and realizes it has to make changes that are in the best interest of the company and the government as an investor," said Mike Stevens, the senior vice president for regulatory policy for the Conference of State Bank Supervisors in Washington. "This will be a great test case to see if it lays the groundwork for the company to raise private capital."

The Treasury appears to be thinking along those lines. An agency spokeswoman said through an e-mail that the strategy provides a bridge to private capital and that the Treasury would evaluate other proposals on a case-by-case basis.

Citigroup Inc. is the only other company that the Treasury has permitted to convert its Tarp investment to common equity.

A few others have converted Tarp funds to trust-preferred securities, including the $3.2 billion-asset Superior Bancorp in Birmingham, Ala., which converted in January, and the $35 billion-asset Popular Inc. in San Juan, Puerto Rico, which converted last August.

Midwest announced in January that it had persuaded holders of $35.4 million of preferred stock to convert those shares into common equity. By the end of this week the Treasury is expected to convert its preferred shares into mandatorily convertible preferred shares.

"This is a critical component of our plan," Roberto R. Herencia, Midwest's chief executive, said in an interview Wednesday. "Most people didn't believe that it was possible to get this done."

Though the Treasury has the ability to exchange the new preferred shares for common equity at will, the company has the ability to compel the agency to do so should it raise the required $125 million in capital. It also must persuade its senior lender to convert a $78.8 million bank stock loan into common equity.

Midwest has said negotiations are in an advanced stage with its lender, Marshall & Ilsley Corp. Winning the Treasury's approval for the Tarp conversion should be a big help in those talks and in securing the $125 million in additional equity.

"There was no way we were going to get a dollar of equity without converting existing stakeholders into common shareholders," Herencia said. "There was a lot of apprehension by new equity as to not wanting to invest the time until the conversions happened. This clears the room and gives them a clear line of sight."

Michael Iannaccone, president of MDI Investments Inc. in Chicago, agreed that the simplified capital structure and the Treasury's willingness to work with the company will likely make it easier for Midwest to raise capital.

However, given its high level of nonperforming assets and exposure to construction loans, Iannaccone said Midwest likely needs more than $125 million of capital.

"Certainly, this makes it easier. This is an important step in their recapitalization plan," he said. "But my big question is, is $125 million enough?"

Herencia said that though Midwest must raise at least $125 million, it would likely seek a larger infusion to provide additional cushion for future losses. He would not disclose the amount he would ideally like to raise.

Though analysts called Midwest's announcement a step in the right direction, some were skeptical.

"To me, they are a lost cause. It is a very wounded bank and in this environment, wounded entities just don't turn around," said Jeff K. Davis, a longtime industry analyst. "If I am an equity investor, why would I put $125 million into this company when I could buy a healthy bank or a failure?"

Davis said the Treasury's approval of the conversion likely was driven by the enormous $64.5 million impairment charge the company was forced to take on its investments in Fannie Mae and Freddie Mac securities after the government's seizure of the government-sponsored enterprises in September 2008.

That cut meant the Tarp investment effectively plugged a hole instead of serving as a buffer for the credit problems Midwest has encountered since then.

"My guess is that the Treasury's decision to go the extra mile with Midwest is political," Davis said. "They are in Chicago, the hometown of our current president, and these guys got burned by actions taken by [former Treasury] Secretary Paulson."

As of Dec. 31, Midwest's tangible common equity ratio was negative 4.30%.

On a pro forma basis, the Tarp conversion — along with the company's conversion of other preferred shares into common equity — would bring that ratio to negative 0.6%, according to a note published by Eileen Rooney, an analyst at KBW Inc.'s Keefe, Bruyette & Woods Inc.

On Dec. 31 the company had $312.4 million of nonperforming assets, making up 9.09% of total assets, up 270% from a year earlier. It posted a loss of $242.7 million for 2009, 56% bigger than its 2008 loss.

The Treasury's approval of this conversion might be a harbinger for Anchor BanCorp Wisconsin in Madison.

Late last year the $4.6 billion-asset Anchor said it had a $400 million capital commitment from Badger Capital LLC, a private-equity firm in Inverness, Ill., that was tied to Anchor's ability to convert its $116 million in Tarp funds into common shares.

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