US Treasury Faces Dilemma Over Banks' Common Equity
February 09 2009 - 2:57PM
Dow Jones News
The U.S. Treasury is facing a dwindling number of options for
strengthening the nation's banks without owning many of them
outright.
When Treasury Secretary Timothy Geithner announces on Tuesday
the U.S. government's latest effort to shore up the financial
system, investors will be listening closely to hear how federal
banking regulators plan to address banks' razor-thin levels of
common equity.
Initial reports of the government's deliberations include plans
to make new preferred investments in banks that would convert to
common shares after a number of years - possibly seven - which
means the government may try to gradually boost banks' common
equity levels over years, rather than weeks. If regulators can wait
to convert the government's stakes to common shares until banks'
share prices recover, they can likely avoid scaring off private
investors by heavily diluting shareholders.
"Under the new proposal, it appears that the government may
selectively convert the preferred TARP shares into common equity
over a seven-year period thus minimizing the dilutive impact," said
Anthony Polini, an analyst at Raymond James Financial Inc. (RJF),
in a note to investors on Monday.
"The key factor," Polini says, "will ultimately be where these
stocks are trading when they finally do raise common equity" -
whether from the government or by issuing shares on the open
market. The higher the share price, the less dilutive those equity
raises will be.
Investors largely agree that most banks are in dire need of
common equity. Since a bank's common shareholders take losses on
the balance sheet before preferred shareholders and debt holders,
the last 18 months of heavy losses have left common shareholders
with shriveled stakes, even though many banks issued new shares
before investors' appetites dried up.
What's more, since the government first began investing in banks
last October, it has done so by purchasing preferred shares rather
than common shares, through the Treasury's Troubled Assets Relief
Program. Holding preferred shares, instead of common shares,
allowed the Treasury to avoid holding voting rights in banks, and
also to cushion taxpayers against future losses.
But over that same time, the largest U.S. banks have racked up
billions in additional losses and seen their share prices sink
fast. Their tangible common equity ratios - or a measure of
shareholder's equity as a percentage of a bank's total hard assets
- have fallen with them.
Of the largest U.S. banks, Citigroup Inc. (C) has the lowest
tangible equity ratio, about 1.2%, according to a report on Monday
from analysts at Keefe Bruyette & Woods. Wells Fargo & Co.
(WFC) has the second lowest, at 2.6%. Bank of America Corp. (BAC)
and JPMorgan Chase & Co. (JPM) have ratios of 2.7% and 3.7%,
respectively.
Those ratios are all far short of the historical norm of about
6%.
Low tangible common equity ratios can be a sign to investors
that a firm may soon need to raise more common equity, which at low
stock prices dilutes existing shareholders to a great extent. This
concern has been a factor in the decline of bank stocks in the last
three months.
The simplest way for the government to boost banks' common
equity would be to convert its current TARP preferred shares into
common shares. But doing so would open a whole new can of worms,
since the government would then own many banks outright.
According to the same Keefe Bruyette & Woods report, the
government would own 66% of Bank of America if it converted its
current preferred shares in the firm into common shares. Under the
same scenario, it would own 37% of Wells Fargo and 27% of JPMorgan.
The report did not provide an estimated government stake for
Citigroup.
Under that same scenario, the report said the government would
also own majority stakes in a number of other banks, including
Fifth Third Bancorp. (FITB), CIT Group Inc. (CIT), Marshall &
Ilsley Corp. (MI) and KeyCorp (KEY).
In recent days, as the Treasury has worked to design its next
rescue package for the financial sector, fears quickly spread that
the government might soon nationalize one or more banks. Those
fears were largely responsible last week for sending Bank of
America's shares to lows not seen since 1984.
Amid those fears, Secretary Geithner is likely to avoid any
suggestion that the government is thinking of nationalizing a bank,
and could duck altogether the question of converting its preferred
shares into common shares.
"It is possible, and we think probable, that the government
[will] not announce whether it intends to convert the current
preferred shares it holds in banks into common," wrote Brian
Gardner, the author of the Keefe Bruyette report.
But there is "one thing we are confident about," wrote Gardner.
"The word 'nationalization' will not pass Secretary Geithner's lips
on Tuesday."
-By Marshall Eckblad, Dow Jones Newswires; 201-938-4306;
marshall.eckblad@dowjones.com