How to fund financial system stablization
Word on the street today is that the Obama administration’s proposed budget includes a $250 “placeholder” for support of the financial system. (ht Economics of Contempt, Calculated Risk) President Obama made an admirable commitment “to restoring a sense of honesty and accountability to our budget”. However, his administration has failed to live up to that commitment with respect to financial system support. Unusually for government expenditures, the budgeted $250 billion dollars represents an estimated “net cost”. It presumes recovery of a substantial fraction of funds “invested” and actually enables cash payments that might amount to $750B. (See EoC, Marc Ambinder.). In plain English, buried in a $3.55 trillion dollar budget as a $250 billion dollar placeholder is a plan to more than double the controversial and unpopular TARP program, whose original enactment nearly tore the political system apart.
We do have a bit more transparency this time about how the “Capital Assistance Program” will be managed. Taxpayers will purchase securities at prices which, as Michael Shedlock points out, appear to have been back-dated in order to give taxpayers a raw deal. In an astonishing abuse of the customary language of finance, the “convertible preferred” shares the government intends to purchase, in addition to mandatory conversion after seven years, are convertible to common stock at the option of the the banks, rather than at the option of the taxpayers holding the securities. James Kwak unearthed this bit of chicanery in the must read piece of the day. In addition, existing bank shareholders would be protected upon any conversion by “customary anti-dilution adjustments”. God forbid that shareholders in bankrupt institutions who would otherwise be wiped out entirely get diluted. The poor dears. (To be fair, it is inaccurate to characterize all institutions that will receive “capital assistance” as bankrupt. The new Treasury Secretary will almost certainly continue the old Treasury Secretary’s strategy of “encouraging” healthy institutions to take government money, so that angry taxpayers cannot use acceptance of funds as evidence that a bank is in trouble. Under the new program, any publicly listed US bank can apply for a capital infusion of up to 2% of risk-weighted assets as a matter of course.)
President Obama’s obvious intellect, idealism, and diplomacy are a breath of fresh air for a nation whose economic and political institutions have suffered a near catastrophic collapse. But the President cannot put his imprimatur on continued financial obscurantism and expect to retain a reputation for honesty and transparent government. It is wonderful that the President intends to come clean and account for the wars in Iraq and Afghanistan on-budget. But Mr. President, past and proposed expenditures to support the financial system dwarf the total financial costs of both those wars combined. This is not a small thing. You can’t hide the terms of these transfers in fine-print befitting a credit-card agreement and expect to retain your reputation with the American people for forthrightness.
Here is my advice to the U.S. Congress: Put $750B in the budget, right up front, for financial system stabilization. But don’t contribute another dime to Secretary Geithner and Neal Kashkari‘s little slush fund. Allocate funds to the sole use of the FDIC, for resolution of troubled banks as foreseen by Congress under the FDICIA (text). See this excellent piece by former bank regulator William Black. The government has been flouting the terms of a binding legal regime designed precisely to resolve insolvent and near insolvent banks transparently, at least cost to the taxpayer, in a manner that minimizes both moral hazard and systemic risk. Former Secretary Paulson’s ad hoc let’s-pretend approach has been tried, and has failed. Why not try following our own laws?
We have a new administration in Washington that claims to be committed to the rule of law and good governance. Congress should help the President achieve these goals by funding an accountable FDIC rather than by putting more discretionary funds into the hands of a compromised Treasury secretary.
Update: The always excellent Nemo also noticed the odd reverse-optionality of CAP “convertible preferreds”. He finds the coincidence of widely publicized insider purchases during CAP’s price-determining 20-day window to be intriguing as well. Purchasing shares with the intention of increasing their effective price to taxpayers under a foreseen government relief program would certainly constitute a crime. What did Ken Lewis know, and when did he know it?
(It’s worth mentioning that the allegation of backdating and that of insider price manipulation are mutually inconsistent — if insiders knew that the window would be 20 days preceding Feb 9 in late January, that implies the price-determining date was appropriately set in the future. You can either suggest that the date was chosen retrospectively, or that it was chosen in advance and shares were bought and talked up, but you’ve got to pick one conspiracy and stick with it. I guess if you’re really cynical, you might suggest that Feb 9 was tentatively chosen in advance, but only finalized when it was clear in retrospect that prices were advantageous, relatively speaking…)
- 26-Feb-2009, 5:15 p.m. EST: Added update re Nemo’s posts.
- 26-Feb-2009, 5:25 p.m. EST: Added bit about inconsistency between back-dating and price-manipulation stories, and hedged the main text a bit, saying that the window appears to have been backdated rather than stating that as though it were fact.
- 26-Feb-2009, 6:05 p.m. EST: Removed an “as the” to split an overlong compound sentence about Geithner countinuing to encourage healthy institutions to accept money so the zombies blend in.
Bank of America executives also purchased suspicious amounts of their own stock in the latter half of January and first week of February. They did not purchase any more even at half those prices after Feb 9. In fact the purchases stop rather suddenly…
Were they attempting to pump their stock during the 20-day window? Or is that too conspiracy theorist?
By the way, Dr. Kwak was not the only blogger to note the reversal of the usual “conversion option”. Just saying. :-)
February 26th, 2009 at 4:56 pm PST
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Wiped out? My idea of wiped out for these clowns involves a tree, rope and horse. That’s the way to wipe them out. Let’s start with Vikram Pandit. Yeah.
February 26th, 2009 at 5:25 pm PST
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How to fund financial system stabilization: something I’ve been advocating for a long time, a Tobin-esque tax on all financial transactions, with the rate increasing directly in proportion to the systemic risk generated by the instrument.
How not to fund it: Obama’s plan to steeply increase taxes on income for those earning over $250k/year. I REALLY hate to sound like a Republican on this one, but taxing small business owners, doctors, lawyers, and other professionals who had nothing to do with the crisis strikes me as eminently unfair and boneheaded.
I’d also love to see Steve do an entry on the rumored USG backstopping of AIG’s CDS portfolio. We may as well announce a program to eliminate all downside risk in financial investment, call it the Guaranteed Annual Return on Bogus Assets Government Enterprise or GARBAGE for short. As I commented over at Calculated Risk, next we’ll see the government backstopping losses resulting from bets on the SUperbowl.
February 26th, 2009 at 5:38 pm PST
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Steve —
Feb 9 is also the day before Geithner’s “announcement of the plan”. Which, granted, turned out not to be much of an announcement. But the date is arguably not completely arbitrary. And according to rumors, Geithner’s announcement was supposed to be a little more detailed, but was gutted at the last minute to give them more time to finalize the details.
Jamie Dimon also bought $11.4 million of his own stock in late January, by the way. Deliberate or not, these purchases did create a short-term pop in the stocks precisely when it would be worst for taxpayers under the terms of the CAP.
I hate conspiracy theories, but the buying pattern (especially at BofA) really does look odd.
February 26th, 2009 at 5:47 pm PST
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It’s really atrocious how the bizarre accounting definitions used by USG are turning around and screwing the taxpayer, purportedly in his own interest.
Example: if USG assumes Citi’s liabilities (eg, replacing them with FRNs of equivalent maturity) in exchange for its toxic assets, the taxpayer at least gets the full upside on these assets. If it issues free loan guarantees to Citi, the taxpayer eats the downside and loses the upside.
But the former has to be booked as “spending,” whereas the latter can be swept under the accounting rug using this kind of cr*p. This is where the archaic illusion that a dollar is some kind of limited resource, not a USG share which USG can dilute indefinitely for whatever reason, bites everyone on the ass. In the usual democratic fashion, public policy is being made in a way that reflects the formal narrative, rather than the reality behind it.
So I disagree with IA. Rope is too good for these people.
February 26th, 2009 at 6:49 pm PST
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Please tell me how the following devil’s formulation is wrong.
(I’m only channelling this):
The motivation for a normal conversion option on a convertible preferred is to make money for the investor, on the basis of an existing, going concern capitalization. That’s why it’s structured as a call option.
The motivation for this reverse conversion option is to recapitalize the issuer, in the event of an existing, failing capitalization.
This is capital insurance combined with a normal convertible preferred (I think the latter, maybe not). That’s why it’s structured to include a put option.
Given the objective of providing capital insurance, it is not structured “backwards”.
Obviously, Treasury isn’t going to allow a bank that pulls the trigger on capital insurance to start buying back its own shares in the market, if its condition deteriorates even more so after the insurance claim is triggered. And without that authority, the economics of the put have no unique equity value to non-government shareholder management. It’s not a free put option or even a put option in that sense.
It is only a put option in the sense of ensuring sufficient common equity in the capital structure under conditions of additional duress.
Importantly, a put option on capital structure is not the same thing as a put option on equity value.
So the criticism of this structure is primarily a criticism of its capital insurance component. Fair enough. But assuming an objective of providing capital insurance, I don’t see how providing the issuer with the option to convert the capital structure is “backward”.
February 26th, 2009 at 7:15 pm PST
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MM:
As usual, you have distinguished the substance from the form. That said, if you think “Rope is too good for these people”, what do you suggest? Burning at the stake? If so, I will defer to you. Burning at the stake it is.
February 26th, 2009 at 8:02 pm PST
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JKH — You and the demons you channel… OK, your demons have me riled up. This is addressed to them.
“Capital structure insurance” is not how these “investments” are being represented to the public. The banks are paying negative premia, since the preferred is offered at a lower coupon than they could achieve in the private market. If we think of CAP as a form of insurance, it is insurance offered for cheaper than free, that is it is a wealth transfer.
It is indisputable that the banks’ option to convert represents a valuable asset for bank managers and shareholders. But the recapitalization is being spun to the public as government investment, not as a transfer to bank managers and shareholders. Characterizations like “convertible preferred stock”, which are frequently used by private, profit maximizing investors to manage uncertainty, are consistent with a taxpayer-friendly view that the government is effectively resolving a market-failure. Under that story, these are good enterprises going forward, but due to some combination of panic, scale, and illiquidity, private investors are incapable or unwilling to step forward to do well by doing good, so taxpayers are doing so instead.
That was clearly the characterization promoted by Paulson with the original TARP. To Treasury’s credit, it is being promoted less and less, as it is obvious that these are not profitmaking or even breakeven investments. But, a corollary of that fact, if they are expected-loss-making investments, is that they are transfers to existing stakeholders, albeit arguably with sufficient positive externalities as to make them worthwhile.
If Treasury wants to make transfers, it may make transfers, and make the case for those externalities. The most effective transfer from the point of view of protecting bank managers and existing shareholders by enhancing capitalization under all measures is for Treasury to simply purchase common stock at an unreasonably high price. That is what Treasury has set itself up to do.
But rather than owning up and arguing for the transfers, Treasury is pretending to invest like Warren Buffet would invest, using the same words to describe the instruments it is “purchasing” that Warren Buffet might use. But it is in fact giving away public money.
“Assuming an objective of providing capital insurance” at negative premium is an assumption too far, because the public has not agreed and would not agree to offer such insurance. You may think of this as a surreptitious transfer of a put option on common stock, or you may think of it as a surreptious transfer of underpriced insurance. It doesn’t matter. Options can always be viewed as insurance. If they are given away for free, that is a transfer.
If an option is written for free and the words used to describe the arrangement are words typically used to describe an arrangement where the party writing the option would ordinarily hold the option, that is obfuscation, and in this case I would call it corruption.
You are right that existing shareholders won’t distribute the proceeds of exercising their put via buybacks or dividends. That doesn’t make these options any less valuable in aggregate to existing stakeholders, who are on the verge of being wiped out, absent transfers. Bank managers certainly will have already drawn salaries out of the original “preferred equity” infusion. And if these enterprises are foolishly permitted to survive this crisis without defenestrating existing stakeholders, both managers and shareholders will own a substantially larger fraction of the resusciated and suddenly valuable firm than they would be entitled to without this subterfuge. In expectation, these are extraordinarily valuable options, in-the-money put options, for existing stakeholders.
I cannot believe that this is my government.
February 26th, 2009 at 8:33 pm PST
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Thanks, SRW.
I feel better now. My head stopped doing a 360.
:)
But I may have a few more points in due course.
February 26th, 2009 at 8:52 pm PST
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These attempts at subterfuge and deception are par for the course. It hasn’t been that long since AIG generously loaned the Fed toxic assets in exchange for cash collateral. That was Hutzpah in how transparent it was. Maybe they’re not as comfortable giving us the finger these days, hence a slightly more sophisticated con.
I do sense a bit of a shift in the zeitgeist on all of this corruption. There is a lot more sustained and vocal criticism from former collaborators. The question is if it will go far enough fast enough to trigger a change before an inflection point on the path to a collapse in the “full faith and credit” of “our” government or its currency.
That risk reminds me of Bernanke’s recent bragging about how the Fed hasn’t lost a dime in all of these bailouts (obviously Maiden Lane LLC doesn’t count). I’m sure Madoff, and probably Ponzi himself, could have said the same thing, until, uh, things changed.
February 26th, 2009 at 10:41 pm PST
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Business history teaches:
(1) industry regulations typically change in reaction to the success of innovators in the industry [1]
(2) innovators typically succeed by being disruptive (i.e., by starting out with a business model that is nothing like the model of the incumbents) [2]
So a high-leverage intervention, specific to subduing incumbents in the financial sector, should center on identifying a business model for next-gen banks.
Q.E.D. :-)
My would-be model for a next-gen bank is adapted at http://www.landofopportunitv.com
Thoughts?
Best,
[1] The Innovator’s Prescription, by Clayton Christensen
[2] The Innovator’s Solution, by Clayton Christensen
February 26th, 2009 at 11:15 pm PST
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All the economic theories informing policy were made for yesterday. I applaud the humanistic initiatives of the President’s budget, but doubt his ability to do arithmetic or to think independently of his banking- and hedge fund-friendly advisors.
And I can’t believe the Chinese and Japanese together are going to be able to lend us all this money over years to come, as their economies are in worse shape than ours, and our consumer–their biggest customer–is a basket case who’s home equity ATM has been slammed shut.
And if you believe, as some of the physicists and I do, that we’re at the crest of the greatest climacteric in human history, the singularity at the end of the growth era, all this econo-macho talk of “output gaps” and “back of the envelope multiplier calculations” to “fix” the economy are pitiful.
I expect monetary chaos within ten years–something new. I expected the credit collapse and deflation, although it has scared me more than I thought it would. But I never used to worry about a total collapse of the monetary system–“paper” money becoming as worthless as it looks–and now I do.
February 27th, 2009 at 12:27 am PST
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in case you might have suspected that pimco (shadow treas/fed) has been writing the script all along…
The Bill and Paul Show
god help us all…
February 27th, 2009 at 1:26 am PST
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Hard as it may be to believe, but the US is headed straight for a banana republic status. The US govt. has officially LOST IT. They are completely clueless on EVERYTHING. The best they could do in this dire situation was to come up with a budget full of pork randomly throwing money here and there without any purpose or rhyme and reason. They are just making a bad situation worse and worse everyday. Obama is just a figurehead and a puppet in the hands of the banking cabal. He doesn’t have a clue either. I can’t believe the US elctorate is so naive. How can he be epected to go against the very people who got him elected, i.e., the financial services industry. I have now NO DOUBT in my mind that the US and the dollar are completely FINISHED.
February 27th, 2009 at 4:34 am PST
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Steve
– Is the indigation rightly directed at shareholders, or should it be directed at bank debt holders?
Shareholders have had 90%+ of the investment wiped out. Even with all the support, money is not pouring in to bank shares as a sure fire one way bet. Whilst messy, the uncertainty about what the government might do has ensured the shareholder wipe-down remains. And, in the (unlikely) event that in a couple of years time, bank shareholders are sipping champagne with taxpayers carry the loss of toxic assets affecting government services and pushing up taxes, who would want to bet against a populist politican coming up with the Taxpayer Repayment Tax/Levy, levied on bank profits to repay the government.
So as a purist, I agree that total shareholder wipeout would seem perfect. As a realist, Joe the fireman’s pension plan suffering a 90% wipeout on bank shareholding is real pain.
A separate issue is Wall Street’s role as ‘professional’ managers. The underlying shareholder gets wiped down, but the ‘professional manager’ continues relatively unscathed, taking 1-3% of capital every year from poor old Joe……..
So who is really avoiding pain? Debtholders in Banks are suffering absolutely no pain at all. Full repayment, full interest. Who suffers against the risk they thought they were taking? Government Treasury holders. They invested in government Treasurys at lower returns than investing in banks to avoid risk, yet now they find they have been dudded. They have in effect been taking risk without being paid for it. The present approach is transferring the pain to the Chinese and old fashioned, risk averse domestic savers that had gone for Government securities.
Why would USG do this? Pain is being forced onto smallest voting block, largely offshore Government Treasury investors. Is there strong logic to doing this? Absolutely. Real question is how the offshore investors react……
Solution? Regulate/limit interbank liabilities. Problem has parrallels to the equity based Keiretsu in Japan for industrial companies late last century. Except in the US/financial services world, the Keiretsu is debt based. Whatever three letter acronym is used, issue is the level of interbank-liabilities between banks, not the instruments themselves. Kill the proprietary trading desks. Limit and regulate liabilities between banks.
Go for inter-bank liabilities, go for the ‘professional’ pension fund manager as the ones escaping scot free. Accept that Joe the wiped down bank shareholder is one person that has already taken pain in this mess…
February 27th, 2009 at 4:49 am PST
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SW:
You write, “I cannot believe that this is my government”. It isn’t. It’s “government of the banks, by the banks and for the banks”.
GG:
Got gold? Get more.
February 27th, 2009 at 8:33 am PST
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IA:
On reflection, I feel that they should be given a not over-generous pension and allowed to live out their lies – I mean, lives – in isolated ignominy, like former Stasi generals.
Perhaps after 20 years VH1 could do a “where are they now?” The Bandit will be running a motel in Burlington, Iowa – the Big Citi Inn. Tim Geithner will be on disability in a trailer park in Oregon – the reporter will be deterred by his aging but still-vicious pit mix, Tarp. And Barack Obama, landing on his feet as always, will have started a new career as the maitre d’ at Charleston’s finest French restaurant, Le Maison Blanc. Can’t you just see ’em?
February 27th, 2009 at 12:56 pm PST
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I cannot believe that this is my government.
I can.
February 27th, 2009 at 1:11 pm PST
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Perhaps I can play devil’s advocate?
Japan’s persistent zombie status was caused, in part, by keeping insolvent banks on life support: ie. not letting them go under, but not recapitalizing them to the extent required to return them to health. Popular rage against a bailout limited what Government agents could do.
There is similar popular rage in the US, and it’s likely that a second, $750B TARP will not be passed by Congress. Given the broad unpopularity of bank recapitalization, the best strategy for the Fed is to recapitalize in a covert way that can slide under the voters noses without them being any the wiser.
Certainly, no one here believes that populism makes for good policy (Mencius?) and in areas as arcane and technical as bank finance, this is even more true. The Fed finds itself having to carry out a task that is correct and important for the economy, but irretrievably unpopular. So it engages in deceit. SRW may want the truth, but we cannot handle the truth. Such is the burden of Governance.
February 27th, 2009 at 4:19 pm PST
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Ah yes, Winterspeak, the burden of Governance: private jets to luxury junkets; lining up a lavish retirement, etc. What a sacrifice.
The historical record is quite clear and consistent as to the results of rising corruption. It never ends well. Populism has nothing to do with it.
I infer from what you write on behalf of the Devil that he thinks withholding trillions of dollars from corrupt banksters would inevitably lead to a disaster, which justifies open-ended bailouts. Furthermore, I infer the Devil has confidence in the competence of the Fed, as well as the current management at the big banks. Quite fitting, I suppose. If I am mistaken in doing so, your “devil’s advocate” post is that much more puzzling.
Now, have you seriously considered and analyzed the possibility that these bailouts could grow so large so as to lead to a much larger disaster that would be much more difficult to emerge from peacefully? I haven’t seen anything resembling such consideration from any of the bailout apologists (while the Devil may be one, I am not suggesting you are – I don’t know.)
How about alternatives that would be much less risky (e.g. shareholder and management wipeout, selective cancellation of a number of toxic derivatives, haircuts for creditors other than insured depositors, a special bankruptcy regime to account for the nature of this crisis, etc.?)
As to the implicit confidence in the Fed, all of the evidence I’ve seen indicates gross incompetence and negligence in looking the other way and ignoring warnings, if not outright enabling of all of the abuses that led us here. Take another look at Steve’s recent zombie bank post as well as his past posts on the various milestones even prior to the Bear Stearns debacle.
Talk it over again with the Devil and see if he’s reconsidered his position in light of the evidence.
February 27th, 2009 at 5:18 pm PST
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BSG: The devil merely points out that banks have to recapitalized, but popular sentiment makes this politically impossible.
Therefore it needs to be done on the sly.
February 27th, 2009 at 7:58 pm PST
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this post seems to explain what they are possibly up to with citi:
http://angrybear.blogspot.com/2009/02/treasury-and-citi.html
essentially: how do you force debt restructuring without either a takeover or a bankruptcy? you use the threat of bankruptcy, and you protect against takeover by always having a pair.
February 27th, 2009 at 10:04 pm PST
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WS – zombie banks have to be actively dismantled, not recaptitalized.
If honesty is restored (I know, how quaint!) popular sentiment would become irrelevant, as there would be plenty of private capital available. Of course, current levels of debts are unsustainable. As they go down, so will the level of required capital.
February 27th, 2009 at 10:09 pm PST
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Martin Mayer on the huge invisible house of cards in the sky hanging over the banking crisis (this is why they can’t do anything but feed the zombies):
Source
February 27th, 2009 at 11:24 pm PST
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MM:
I read the 1884 piece. What’s your point? Since before the Republic was founded, monetary policy has been disputed. In the 1770s we heard the phrase, “not worth a continental”, referring to the approximate 400X price increase in paper currency from 1776 to 1781. In 1862 Lincoln issued greenbacks which were retired between 1873 and 1879 when we returned to gold. Various governmental authorities have always wanted to issue “bills of credit”. Would Arnold Schwartzenegger issue them if he could? So? Defaulting on debt is what governments do. All of them, the ill-founded opinion of Walter Wriston notwithstanding.
Winterspeak:
Why must banks be recapitalized? I don’t think they do. Let them fail.
February 28th, 2009 at 12:46 am PST
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IA,
SRW was stating, or appeared to be stating, that these sorts of peculations were atypical and unexpected for the government in question, USG. Bancroft’s essay (the author is considered perhaps the founder of American history as a discipline) shows nothing but the contrary. Since even before USG’s birth, North America has been the home of funny money and corrupt connections between government and bank.
The greenbacks, BTW, were not ‘retired’ in the sense that I would use the word, ie, called in and replaced with physical gold. Rather, USG in the Gilded Age found itself capable (to the surprise of the entire world) of maintaining redeemable notes at par. This is a very different thing than saying it had enough present gold to redeem all current dollars, which it didn’t.
One of the many tragedies of the Civil War was the effective demise of the Independent Treasury System, which at least in its design was perhaps the only sound monetary system the US ever saw. Under ITS, designed by hard-money Democrats like Condy Raguet, USG was supposed to receive all taxes in specie and keep all cash on hand in its own vault, effectively separating itself from the banking system for the first (and last) time in American history. This was only starting to get off the ground before the war, which of course killed it.
But history records other governments, and traditions of government. I’m not aware, for example, that the Kingdom of Prussia ever defaulted on a loan. In general, Continental countries used hard money and were somewhat weirded out by the paper pyramids of the Anglophone governing tradition.
February 28th, 2009 at 2:15 am PST
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winterspeak said: “Given the broad unpopularity of bank recapitalization, the best strategy for the Fed is to recapitalize in a covert way that can slide under the voters noses without them being any the wiser.”
I don’t know if I would call it the “best” strategy as that implies a normative value judgement, but I agree with you that it definitely IS THE strategy being pursued.
Once the powers that be saw the difference between 1) what it took to get the $700 billion TARP program passed by Congress (before, during and after passage) and 2) what it takes for the Fed to create a new alphabet soup program (nothing, save a one page press release), there was no doubt as to how future bailouts would be done. Expedience, for better or worse, won the day by a landslide.
February 28th, 2009 at 7:19 am PST
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MM:
I now understand. We had misunderstood each other. I referred to “greenbacks”, i.e., the $431 million of notes issued from 1862-1864. In 1875 the Resumption Act required Uncle Sam redeem these notes in 1879, in coin. Yes, the ITS was a good system.
February 28th, 2009 at 5:39 pm PST
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Yes, the greenbacks are the notes I meant. But there’s a big difference between making the notes redeemable (effectively, pegging them to gold), and actually calling them in and redeeming them.
Again, all the 19th-century systems collectively described as the “gold standard” consisted of redeemable claims backed by a blend of gold and loans. With enough gold and good enough loans, this could be made to fly, sort of. Although it was still full of panics, crashes, busts and booms.
I suspect that in a frictionless computerized financial system, it would be harder to hold a mixed “gold standard” like this together. A bank run can happen awful fast on teh Intertubes.
March 1st, 2009 at 12:51 am PST
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SRW,
Apart from Treasury’s apparent obfuscation of the unconventional nature of the preferred equity conversion option, I think the interpretation of the put value is context dependent.
I can see how a bank issuing preferred stock with right of the bank to convert into common resembles a free put option (or capital insurance), whose value appears to be the difference between the strike price and the stock price.
However, such preferred stock is one of several capitalization alternatives. Compared to the alternative of originally issuing common shares instead, at the same price as the preferred strike, the put option itself offers no incremental value that I can detect. Immediately issued common shares would offer essentially the same embedded put protection for the existing shareholders.
Moreover, the conversion price is set as a rate of exchange of par value preferred stock for common stock. But the value of preferred stock changes between issuance and conversion. While conversion becomes increasingly attractive when the common stock is driven lower, it is also likely that the preferred stock price will have fallen as well. This is because the same conditions that drive the common lower increase the probability that preferred equity will be wiped out as well. Therefore, the total market value of the converted capital is less. Therefore, while the conversion ratio hasn’t changed, the effective conversion price is lower than the strike price. This erodes the effective put value of the conversion relative to the strike price.
Thus, the conversion value is not the same as it would have been with an injection of new common equity as cash. That would have been the case had the preferred equity not been issued in the first place, and the put option were a cash option rather than a conversion option. As it is, some of the conversion put value has already been absorbed by the presence of the preferred equity itself rather than the conversion option. This absorption could be attributed to an embedded put on existing preferred equity just as there would have been an embedded put on alternative common equity as noted above.
A similar effect was realized in Friday’s conversion of the government’s Citigroup preferred to common. This was not the result of an issuer’s put per se, but the benefit of the embedded put on the preferred was realized by Citi shareholders nevertheless. The preferred stock had already absorbed an expected value loss that would otherwise have been borne by common shareholders under a total common capital structure.
Something along these lines is why I suggested that “a put option on capital structure is not the same thing as a put option on equity value”.
For interesting discussions of the Citigroup effect, see:
http://baselinescenario.com/2009/02/27/
citigroup-arithmetic-explained/
http://zerohedge.blogspot.com/2009/02/
reason-for-todays-persistent-decline-in.html
March 1st, 2009 at 1:58 pm PST
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JKH — If the shares are to be converted to common with certainty, there is little difference between conversion today and a put option. The reason why a put option is advantageous to existing bank shareholders is that it is not exercised with certainty: in a good state of the world, they keep a large stake of the company. In a bad state, they put much of it back. There is no way around this really.
Yes, it’s true that on exercise, the preferred would have already decayed in value some, offsetting the apparent loss realized on conversion. But that offset is partial at best. Cumulative preferred shareholders ultimately lose only on
serious insolvency, if they are willing to hold to maturity. Common is “option value” when preferred really collapses. So for firms not already considered bankrupt (i.e. not Citi and BAC), exercise is likely to force something close to the relative-to-par loss on preferred shareholders.
It has not been emphasized in the discussion, but the CAP securities are much more valuable to the Goldmans and JPMs than to the Citis and BACs. For the certain Zombies, as a commenter at Baseline Scenario pointed out, even overpriced exercised amounts to autonationalization. It is for every other bank that can at will get two percent of its balance sheet financed this way that the embedded put is very, very valuable.
You may be right, WRT to Citi, that it’s not worth getting too upset about the somewhat overpriced-relative-to-par conversion. The taxpayer took its loss on this investment when we “invested” in TARP preferred to begin with. The conversion to common is mostly interesting by virtue of how hard policymakers had to work to avoid nationalizing outright, the whole “dollar-for-dollar public/private conversion” that clearly involved threats of expropriation to persuade the private converters to go along.
So with respect to Citi and BAC, you can argue as you do that the subsidy here is less than it seems, although it is still very material if common ends up not being wiped out. (zombie banks that survive will eventually see a euphoric multiplication of their share value, to which I believe taxpayers are fully entitled, but the taxpayer share of which our policymakers are determined to minimize. this is funny, since of course taxpayers agents will choose which zombie-shareholders live and die, but despite what you’d think, they’re unlikely to do so in a way that maximizes taxpayer value.)
But any bank in the country can take this financing, and that option is very sweet free “insurance” for those banks’ shareholders.
March 2nd, 2009 at 2:52 am PST
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SRW,
Thanks. That helps me understand it better.
Final comments:
“The reason why a put option is advantageous to existing bank shareholders is that it is not exercised with certainty: in a good state of the world, they keep a large stake of the company.”
I realized that but forgot to note it. The preferred shareholder is essentially long a put reflecting the common shareholder’s embedded short put exposure. But the preferred shareholder isn’t similarly exposed to the benefit of the common shareholder’s embedded long call option unless and until the preferred put is exercised and the preferred actually becomes common. (I suppose if the preferred shareholders were able to predict a good state of the world, they could always convert to common for the purpose of capturing the additional benefit of the call exposure (i.e. cheap common equity capital) as opposed to the purpose of seeking “capital protective put” insurance.)
According to “Zero Hedge” (http://zerohedge.blogspot.com/ Friday Feb 27 post), the Citicorp preferred of par value $25 traded as low as $ 4.50 Friday morning, so most of the “put absorption” had already occurred at that point.
To your point about the put benefit in the “non-zombie” case, if the bank recovers strongly after the exercise of the put, one could almost ignore the fact that the preferred had temporarily deteriorated in value and assume ex post that the preferred would have matured at par, so that the realized value of the put is very substantial as you say.
Thanks again for the feedback.
March 2nd, 2009 at 7:45 am PST
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i.e. “cheap common equity” from the perspective of the preferred converters, not, as is normally construed, from the perspective of pre-existing common share holders.
March 2nd, 2009 at 7:55 am PST
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I spend lots of time thinking how media can help resolve the worsening global financial crisis. This weekend I came up with a format idea. A bud about to bloom. And today along comes Steve Randy Waldman with a post that fertilizes it wonderfully. My idea addresses his concern with the “incompatibility between the kind of financial markets we have and open democracy”.
It’s at Weathering the Storm. It’s a windfall for CNBC or it can happen on the Internet. I’m looking for people to help make it happen. Just remember where you saw it first and thank you Steve.
March 2nd, 2009 at 11:51 am PST
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