Talk is swirling around the details of the next bailout plan, set to be revealed Monday. Today´s Financial Times, citing unnamed sources, says Treasury Department officials are examining ways to convert the preferred shares in banks that the government purchased during the Capital Purchase Program into common stock. The article explains:
"The shares would automatically convert into common equity if there were a decline in the bank's health--as measured by its so-called tangible equity ratio, for example. The government may also make future capital injections in the form of such convertible preferred shares. The point would be to provide a drip-feed of additional common equity as needed to cover losses - as opposed to putting in a large amount of common equity up front that could result in the government owning a larger stake in the banks than is necessary."
Mark Flannery, a finance professor at the University of Florida, has been examining a similar idea for converting a company´s debt into common shares. He praised the Treasury´s possible plan, saying it would help the government gain flexibility in managing a failing bank without necessarily engaging in the alarming act of nationalization.
"In the extreme, what would happen would be that the Treasury would wind up owning effectively 100% of the common shares," Mr. Flannery said. "But that would be an extreme result. These banks are so undercapitalized that adding capital would be a good thing by adding common stock. I think it´s a matter of semantics whether you call a large position in a private firm nationalization or not. What matters is how it´s managed."
But it´s worth wondering whether the original idea would work even better. Mr. Flannery he originally thought of creating a structure for debt that could convert it into common shares if necessary. This would have actually added to the bank´s Tier 1 capital by increasing the amount of common shares held by investors.
"I started out suggesting that the conversion be from debt to common and then the amount of Tier 1 capital goes up and the debt goes down. So the situation becomes better," he explained. He said the Treasury´s variation is "not a fatal flaw, but it is a difference."
"The fact that they´re talking about buying more of these preferred and convertibles suggests they´re unwilling to let the bondholders and depositors take any losses," he added.
But there are advantages to converting preferred shares to common stock. "It will rearrange the composition and it will remove the cash flow obligation to pay a big dividend on the preferreds," Mr. Flannery said. But though banks would be under less pressure to pay high dividends, "The government would go from not having voting rights to having voting rights."
Even so, authorities could choose not to exercise the new control they had over banks´ management teams. Also, Mr. Flannery pointed out that even without shareholder voting rights, the government can influence banks´ management decisions. Regulators can direct banks that are determined to be engaging in unsafe and unsound practices to change their management teams.
Still, Mr. Flannery´s version would have been more potent. And Converting debtholders´ stakes into common shares wouldn´t even necessarily wipe them out if they received a number of shares equal to the value of the debt they´d purchased. And it could have had truly positive effect on banks´ capitalization.
In Mr. Flannery´s view, though, the government´s commitment to preserving debtholders has been sealed by its earlier actions, and the conversions from preferred to common are likely all banks can hope to expect. "Whether it´s good or bad," he said, "I think it just is."