Tuesday, October 14, 2008

Treasury to Invest Directly In Banks

The government is set to buy preferred shares in banks. Why do this Adam Levitin of Credit Slips asks? He answers his own question below.

So why did Treasury do the deal as preferred stock?

My guess is that it mainly had to do with bank capital requirements. Both banks and bank holding companies have complex capital adequacy requirements. If violated, various regulatory sanctions are triggered.

Roughly speaking, bank capital is split into Tier 1 and Tier 2 type of capital, depending on the nature of the capital. Tier 1 capital is "core" capital and is more important. The deal appears to be structured to bolster Tier 1 capital, in order to have the biggest bang for the buck in terms of supporting bank capital adequacy. If the deal were done as straight forward debt, it wouldn't help bank capital adequacy, and if it were done as subordinated debt, it would be Tier 2 capital (not as good)...

So it in the end, we have what is basically an economic loan, but structured in a way to game bank capital adequacy requirements. What strange times we live in when Treasury and the Fed have to engineer a deal to circumvent their own regulations.

What is so strange about these regulations? They are there to make sure there is enough "equity" to back up the bank in case of losses. That's why banks have to raise capital instead of just borrowing at the FED window. Think of it this way, if a bank takes losses, it has to do so through equity. You borrow $100 million from the FED, you still owe $100 million. If you lose $20 million due to bad loans, you are insolvent then. But if the FED buys new shares and invests $100 million, then if you lose $20 million, you have $80 million left.

As a consequence, the shareholder also gets to profit from future bank results. So if the bank is able to make $20 million profit, net of expenses like interest, then that goes to the shareholder. With a loan, the government would be paid back, but not be able to participate in future profit gains.

The preferred shares allow the government to profit from future gains, while also getting interest. They are non-voting shares so conflict of interest is minimized, though in reality the government can make new laws and regulations anytime it wants. It can force the banks to do whatever anyway, but it legally shields the government from having to vote. The FED doesn't want to have to vote on thousands of shareholder proposals.

Again, it's all about capital. Capital is important for investors too, banks without enough capital can become insolvent very quickly if they take losses. Capital shields banks from insolvency, which is why banks are required to have a certain amount of capital to cushion themselves. And if the government waives those regulations, investors would have no faith in the ability of the bank to survive, or more accurately, much less faith, even with a government loan.

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