gilmoure calls shenanigans on my Slow News Day post.

gilmoure:

crazynutjob:

There wasn’t really anything worth linking to for jobs headlines today. There really wasn’t much worth looking at today in economic reports. This is a little odd given the fact that the S&P dropped over 4 percent.

…

What do you think of White House plan to take remaining $150B recovery funds and rather than loan to banks, convert to stock in bank, similar to what the Treasury’s done with Citigroup?

My thoughts? It’s a robbery of the taxpayers that won’t work.

I think this is clearly a robbery of the taxpayer. From a trivial risk analysis perspective, having senior debt is superior to having equity. In a bankruptcy, there’s a chance of being made whole with the senior debt. In addition, we get paid for the loan, not for the common stock (dividends have largely disappeared from bank stocks). Sometimes stocks perform better than loans, though. Our government’s loans to the banks come with a fairly high interest rate and warrants for equity. The warrants are essentially call option conversions, which for a normal investor means that if the stock goes up higher than the interest rate paid on the loan, the normal investor can convert to stock to capture the greater gain. Treasury is doing the opposite: the stock has cratered (even with the recent run up), and they’re still buying shares at a discount (using Citigroup as a model).

There are several objectives/justifications. Some of these are real, and some are bogus. The first justification is that banks need more money, and the conversion to common stock frees up a lot of money (the interest payments and loan repayment reserves) without costing additional TARP money. This is true, at the rather large expense of cutting the expected returns to the government coffers. The second justification is that doing this will make it easier for the banks to raise private capital. I think this is also true (again, at a huge expense to the government because of dilution), but it isn’t guaranteed. While Goldman was able to raise private capital ($5 billion last week), I think it’s fair to say that every other bank will face substantial difficulty. A completely bogus justification is that it is easier for the government to exit the position as a common stock holder. While it is true that the common stock could be sold on the open market, the sizable position owned by the government makes this difficult (they’d need to coordinate with a large investment bank to avoid crushing the stock price). Furthermore, I hear that there are a great many people who specialize in securitizing exotic debt agreements who are looking for work. Given that the government controls all the terms of their agreement, this was a very real possibility (this is mostly a joke). The overall objective is still to inject as much money as possible into the banks to help them repair their balance sheets. This is a move in that direction, but there is every reason to expect it to be insufficient. Things are still worse than government officials and banking CEOs are letting on. They’re still living in the fantasy world where 2006 was “normal,” and we’re going to get back there sometime soon.

The Treasury (Geithner in particular today) is drawing some fire that this is a backdoor way of nationalizing the banks. I have to say that I find the idea a bit absurd. If we wanted to nationalize these banks, we could have done it at far less cost. If anything, this has been much more favorable to equity holders and subordinate debt holders than any rational nationalization plan would have been. We have two paths before us. We can nationalize the banks (hopefully temporarily, like bankruptcy conservatorship), or we can continue to throw sacks of money at the problem. We can always jump to the first path from the second, though the longer we stay on the second path, the more expensive it will be. If we take the second path to the end, I think the banking industry will act like a wounded duck for several years.

I’ll state once again, a bankruptcy conservatorship will not be easy. The large banks (bank holding companies like Citigroup) will not be like standard FDIC closures because a huge portion of their companies are not commercial banks. However, I think it is the least costly option (a lot of the value of these companies disappears if they close their doors).