definitive winners and losers, which is exactly the opposite of what the government wanted to do

TO BE NOTED: From Bloomberg:

"Short Selling of Banks Accelerates as New Financial Stress Test

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By Edgar Ortega and Elizabeth Hester

May 4 (Bloomberg) -- Short sellers, the bane of Wall Street executives last year, are back.

The number of Citigroup Inc. shares borrowed and sold short increased sixfold since Feb. 27, the day the U.S. Treasury announced it would convert some of its preferred shares in the New York-based bank into common stock.

Short interest in Bank of America Corp., MetLife Inc. and American Express Co. climbed more than 40 percent in the same period, according to data compiled by Bloomberg. In total, short sales of the 18 publicly traded financial companies undergoing government stress tests were twice as high on April 15 as they were at their peak last year in July, two months before Lehman Brothers Holdings Inc. collapsed.

“People are either positioning themselves for the potential of a preferred-to-common conversion, or they have an increased perception of risk in these companies,” said Andrew Baker, an equity strategist at Jefferies & Co. in New York.

The Federal Reserve plans to release results of the tests on May 7. At least six of the 19 firms under review will require additional capital to absorb losses if the recession worsens, people briefed on the preliminary results said last week.

Short sellers borrow shares and sell them hoping to make a profit by replacing the stock after prices fall.

Douglas Cliggott, manager of the Dover Long/Short Sector Fund in Greenwich, Connecticut, said he is shorting some bank stocks on expectations they will lose value as earnings deteriorate. New York-based hedge fund manager Daniel Loeb is betting that financial firms needing more capital will exchange preferred shares for common to bolster their balance sheets. He’s seeking to profit from the price difference between the two securities by buying preferreds and shorting the common.

Converting Preferreds

Citigroup is in the process of converting as much as $52.5 billion of preferred, including $25 billion held by the government. Charlotte, North Carolina-based Bank of America, the largest U.S. lender by assets, will change $25 billion to $45 billion of preferred shares into common to raise capital, said Richard Staite, an analyst at Atlantic Equities LLP in London, in a report to clients last week.

Wells Fargo & Co., based in San Francisco, and three smaller rivals -- BB&T Corp., SunTrust Banks Inc. and Regions Financial Corp. -- also may have to turn their preferred shares into common as a result of the stress tests, according to analysts at New York-based Creditsights Inc.

To entice investors to accept common shares, companies may offer preferred holders a premium to the current price, said Phillip Jacoby, a managing director of Stamford, Connecticut- based Spectrum Asset Management Inc., which oversees $6 billion. Citigroup is offering holders of the $2.04 billion 8.5 percent Series F preferred $21.70 worth of common shares, 24 percent more than their price of $17.48 as of May 1.

Tangible Common Equity

By exchanging preferred for common, banks would be able to increase their tangible common equity, or TCE, a measure of how much capital a firm has to withstand losses. The financial yardstick strips out intangible assets, goodwill -- the premium above net assets paid for acquisitions -- and preferred stock, including shares issued to the U.S. Treasury.

Regulators want TCE to equal about 4 percent of assets, up from an earlier target of 3 percent, people with knowledge of the situation said last week. Seven of the banks under review have ratios of less than 4 percent, company reports show.

“Banks are going to need more capital,” Jacoby said. “Treasury doesn’t care about dilution. All they care about is financial mass and loss-absorption ability to offset what could be more nonperforming loans and writedowns in the future.”

‘Vicious Cycle’

The increase in short selling occurred as the S&P 500 Financials Index posted its best two months since 1989, when Standard & Poor’s started keeping records. The 80-member index has surged 41 percent since Feb. 27.

Stephen Wood, who helps manage $151 billion as senior strategist at Russell Investments in New York, said the stress tests will narrow the breadth of the rally.

“It will end up resulting in a differentiation of the shares,” Wood said. “It will be a vicious cycle for the companies that are not doing well. The share price will go down in anticipation of dilution with the issuance of new shares.”

Short sellers were accused last year by Wall Street chief executive officers, including Lehman’s Richard S. Fuld and Morgan Stanley’s John J. Mack, of using abusive tactics to attack firms.

SEC Ban

Fuld, 63, told congressional investigators on Oct. 6, less than a month after Lehman filed the biggest bankruptcy in history, that short sellers played a role in a “storm of fear” that led to the demise of the 158-year-old firm. Mack, 64, helped persuade government officials in the days following Lehman’s collapse to suspend short selling, which he said was sending his New York-based firm’s shares into a free fall.

The U.S. Securities and Exchange Commission imposed an emergency ban on bearish bets on more than 900 finance-related companies for a three-week period that ended Oct. 8. The agency also tightened requirements on delivering borrowed securities and imposed rules that require hedge funds to privately report short sales to the agency.

The SEC will convene a meeting May 5 to discuss proposals for restricting short sales, including an outright ban when a stock’s price declines.

“The ban last year crushed a lot of hedge funds and their investment strategies,” Perrie Weiner, a partner at the law firm DLA Piper in Los Angeles, said in a telephone interview. “There are much cooler heads now. They are looking at ways by which they can say, ‘We’ve got a better regulated market, and we are on the road to recovery.’”

Short Interest Rising

Short interest rose after Feb. 27 for 14 of the 18 publicly traded companies under review by the Fed, according to Bloomberg data. Citigroup’s increase was the biggest at 509 percent, followed by New York-based insurer MetLife at 66 percent, American Express at 44 percent and Bank of America at 42 percent. The average increase for the 18 companies was 47 percent. It was 201 percent excluding Citigroup.

Representatives for Citigroup, Bank of America, MetLife, and American Express declined to comment.

Detroit-based GMAC LLC, the auto and mortgage lender that received a $6 billion government bailout and is one of the 19 companies undergoing stress tests, wasn’t included in the Bloomberg data because it isn’t publicly traded.

The total short interest for the 18 firms as of April 15, the last date for which New York Stock Exchange data are available, was 2.1 billion shares, or 7.1 percent of those available for trading. That compares with 1.05 billion shares on July 15, or 4 percent of those available for trading.

‘Winners and Losers’

Excluding Citigroup, which accounted for about half of the increase, the total stood at 866.1 million shares on April 15, higher than all but one period last year and 2.9 percent shy of the July peak.

The number of shares sold short in Morgan Stanley totaled 52 million on April 15. While that’s down 12 percent since Feb. 27, it’s higher than the 45.3 million shares on Sept. 15, when Mack was lobbying lawmakers and regulators for a ban.

The large short positions will fuel volatility in stock prices when regulators announce the results of the stress tests, said Matthew McCormick, a fund manager at Cincinnati-based Bahl & Gaynor Investment Counsel Inc., which oversees $2.1 billion.

“With that massive amount of short interest, what those traders are saying is that they feel this process is not going to be managed well,” said McCormick, whose firm doesn’t own any bank stocks. “There are going to be definitive winners and losers, which is exactly the opposite of what the government wanted to do.”

Shorting Citigroup

Loeb’s Third Point LLC, which oversaw $1.8 billion as of April 1, was among investors shorting Citigroup stock and buying the preferreds. While the bank’s delay in completing the exchange has eroded his returns, Loeb told investors last week that he expects to reap gains when other banks swap preferred for common stock.

“We expect to see more opportunities in this area as restructurings create more movement in markets,” Loeb told his investors in an April 28 note. He confirmed the authenticity of the letter and declined to comment further when contacted by Bloomberg News.

Cliggott, whose fund beat 97 percent of its peers last year, according to Bloomberg data, said he’s short New York- based American Express and Goldman Sachs Group Inc. because of his outlook for diminished earnings for the two firms. He unwound his short positions in New York-based JPMorgan Chase & Co. and Wells Fargo, saying the outcome of the stress tests for those banks is “too big of a wildcard.”

“There are a fair number of people in the marketplace who believe many financial stocks are extremely expensive given the rapid contraction of earnings,” Cliggott said, citing the decrease in leverage in the industry as well as deterioration in consumer credit. “The government has added tremendous uncertainty about the future of the U.S. financial sector.”

To contact the reporter on this story: Edgar Ortega in New York at ebarrales@bloomberg.net; Elizabeth Hester in New York at ehester@bloomberg.net"

should extend conversion offers to their current shareholders before seeking government funds

TO BE NOTED: From Reuters:

"Stress test banks can turn to stakeholders

Fri Apr 24, 2009 12:36pm EDT

By Karey Wutkowski

WASHINGTON (Reuters) - U.S. banks undergoing stress tests that need more capital will be encouraged to first go to their current stakeholders, possibly through conversions of preferred stakes to common equity, Federal Deposit Insurance Corp Chairman Sheila Bair said on Friday.

Bair said any banks deemed to need more capital under the tests for more adverse economic conditions should extend conversion offers to their current shareholders before seeking government funds.

"They just need to make some hard decisions and there should be some fair terms in the conversion offers," Bair said at the Reuters Global Financial Regulation Summit in Washington. "Nobody wants the government money right now so that might be a good lever."

She does not foresee administration officials having to ask Congress for more financial bailout funds after the stress test results are released on May 4.

The U.S. Treasury Department has about $100 billion left in the $700 billion financial rescue fund. Policymakers have said the banks will have six months after the stress tests to raise private capital if more is needed, or they will have access to more government capital.

Bair also said the FDIC plans to meet in late May to reduce its proposed emergency assessment fee on banks to as low as "single digits" from 20 basis points. That reduction is dependent upon Congress approving a proposal to increase the FDIC's borrowing authority with the Treasury, Bair said.

The FDIC proposed the emergency fee -- scheduled to be collected in the third quarter -- to replenish its deposit insurance fund, which has been dwindling due to a sharp upswing in bank failures. The bank industry has said the one-time fee would cost as much as $15 billion at a time when the institutions can least afford it.

Regarding any stress test banks that need more capital, Bair said regulators can talk with those institutions on how to structure conversion offers to their current shareholders.

Regulators have stress tested the largest 19 U.S. banks to see how they would fare if the recession proves to be deeper than expected.

Officials are due to release later on Friday a document that will describe in detail the bank regulators' method of evaluation, including the underlying concepts and variables. The results of the stress tests will be announced on May 4.

Bair said policymakers are still discussing how to release those results. She would not say if results from individual institutions will be disclosed."

handful of the 19 banks to raise significant amounts of new capital and could lead to greater government ownership stakes in the banks.

TO BE NOTED: From the NY Times:

"Regulators Disclose Criteria for Bank ‘Stress Tests’

By ERIC DASH

"Federal regulators released the criteria they used to assess the financial health of the nation’s 19 biggest banks on Friday, but provided little new information for investors to distinguish the industry’s weak players from the strong.

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Documents: How to Design and Conduct a Stress Test

In a 21-page report, the Federal Reserve regulators broadly laid out the tools they used to project bank losses if the economy worsens, and officials established an unspecified baseline to measure how much additional capital the banks should add as a buffer against higher losses. But they provided no concrete metrics to assess the depths of the troubles facing the industry or specific banks.

Still, the Federal Reserve report suggested that regulators are focusing on the amount of capital that they want banks to hold in common stock, which makes it easier for them to absorb future losses as the recession wears on. That could force at least a handful of the 19 banks to raise significant amounts of new capital and could lead to greater government ownership stakes in the banks.

“Losses associated with the deepening recession and financial market turmoil have substantially reduced the capital of some banks,” the Federal Reserve report on the stress test said. “Lower overall levels of capital — especially common equity — along with the uncertain economic environment have eroded public confidence in the amount and quality of capital held by some firms, which is impairing the ability of the banking system to perform its critical role of credit intermediation. “

Despite the limited details, Wall Street analysts and traders are already using whatever glimmers of information that have seeped out to conduct their own “stress tests.” Investors are making bets on which bank stocks may rise or fall even before the official exam results are announced. The stress test criteria were released as federal regulators started briefing top executives from the 19 large banks about how their companies fared on the examination. In closed-door meetings at the regional Federal Reserve Bank offices, the regulators plan to review their preliminary findings and inform bankers if they need additional capital. The banks will have until Tuesday to dispute any of the results before they are made public on May 4.

Wall Street has been buzzing about the stress tests since they were announced two months ago as a cornerstone of the Obama Administration’s plans to aid the nation’s ailing banks and overhaul the regulatory system. The program was designed to bolster confidence in the financial system, with regulators certifying which banks were healthy enough to start returning the government bailout money, and which banks needed additional capital.

But it has turned into a minor quagmire, putting regulators in the awkward position of picking winners and losers and setting off internal debates over how much of the confidential test information to disclose. Federal law requires banks to keep exam results under wraps.

Regulators have not yet formally required banks to increase their levels of core capital, or tangible common equity to protect against losses, but the additional capital cushion moves in that direction. Previously, regulators have suggested that banks maintain a tangible common equity ratio of 3 percent, and focused on a broader metrics of financial strength.

Regulators and investors want banks to increase the amount of tangible capital they hold so they can more quickly write down losses that many still expect from real estate, credit cards and other troubled assets.

Investors are paying close attention to the methodology. Even so, the new information is unlikely to provide a full picture of the banks’ financial condition, said John McDonald, a banking analyst at Sanford C. Bernstein.

The data, for example, does not reflect differences in each bank’s lending standards or their ability to generate revenue. Nor does it account for the fact that banks made more loans in areas like California and Florida, where the housing and job markets have been hardest hit.

Investors and the banks have been bracing for the official findings since early March, when the banks sent regulators their own results of a series of computer-run analyses that looked at what might happen if the economy deteriorated. The tests, overseen by the Federal Reserve, involved more than 150 banking regulators and asked the banks to analyze how a variety of hypothetical situations would affect their loss rates. Those include unemployment rising to 10.3 percent by next year, home prices falling an additional 22 percent this year, and the economy contracting by 3.3 percent this year and staying flat in 2010.

As part of the test, the banks analyzed each category of loans they held and compared their results with the ”high” and ”low” range of government loss estimates. If a bank expected fewer losses than the government did, the regulators asked the institution to explain why. The banks were also asked to project their earnings over the next two years to give the regulators a better sense of how much capital they would have to absorb the coming losses.

Over the last few weeks, top federal officials have been combing through the data to get a handle on the depth of the banks’ losses. They also tried to make apples-to-apples comparisons across all 19 banks before determining how much fresh capital each needs.

Banks will be given the chance to raise money from private investors first, but the fragile condition of some lenders and the short timetable before the results are made public makes it increasingly likely that they will return to the government for money.

Administration officials say that the banks may also be able to convert the government’s existing preferred share investments into common shares. That will allow the Treasury Department avoid returning to Congress for additional bailout money but it also could lead to greater government ownership of the banks."

Goolsbee Says Accuracy Is Key in Bank Stress Tests

TO BE NOTED: From Bloomberg:

Goolsbee Says Accuracy Is Key in Bank Stress Tests

sanctity of the capital structure and to treat differently stakeholders with similar legal rights

TO BE NOTED: From the FT:

"Bank tests we should get stressed about

By Mohamed El-Erian

Published: April 21 2009 20:46 | Last updated: April 21 2009 20:46

With the banking system still under stress, financial markets are waiting with great anticipation for the release by Washington of the results of stress tests for major US banks. Some believe the tests, scheduled to be released in early May, are excessively hyped. They are wrong.

The stress tests will accelerate the redefinition of the financial landscape, with a meaningful impact on future economic growth and welfare. However, whether the impact is for good or ill depends on how the results of the tests, and policies that flow from them, are pursued.

Rightly or wrongly, the February stress-test announcement was interpreted by markets as signalling a comprehensive process through which the government would evaluate the soundness of banks and decide on sustainable solutions for the sector – a sector critical to the economy’s prospects.

In particular, the tests suggested a concrete way to differentiate between the solid institutions that can raise private capital, and those that will (and must) feel a heavy government hand. They could also lead to a way to reconcile the multiple initiatives designed to stabilise a highly disrupted sector that is contaminating many sources of job creation, nationally and internationally.

The US government now has to deliver on those expectations; and it will not be easy. The outcome will be decided by more than the design and execution of the stress tests for the 19 selected institutions. It also depends critically on the announcement, context and follow-up.

To maximise the prospects for a good outcome, or at least minimise the risk of damage, it would be prudent for US policymakers to take seriously the following five factors:

First, transparency is key. Whether the government likes it or not, hundreds of analysts around the world will reverse engineer the stress tests. The government would be well advised to assist the process through clarity. Obfuscation would result in damaging market noise and further derail the real economy. At the minimum, policymakers need to provide credible details on the methodology, the underlying assumptions and scenario analyses.

Second, the results of the stress tests must be part of a comprehensive, forward-looking package to resolve problems at banks. Out-performing banks should be provided with exit mechanisms from the exceptional government support that they have been receiving and, presumably, no longer need. At the other end, there must be clarity as to how capital-deficient banks that no longer have access to private capital will be handled.

Third, the banks’ recovery and rehabilitation efforts must be co-ordinated closely with other efforts to put the banking system back on a viable road. In particular, they need to work together with the implementation of initiatives aimed at lowering funding costs (such as federally-guaranteed borrowings and Federal Reserve facilities), and facilitating the removal of the overhang of toxic assets. This will require a level of co-operation among US agencies that, historically, has not come easily or effectively.

Fourth, the government should arrest and counter the recent erosion in key parameters of the market system. Specifically, it must work hard to resist the temptation to override contracts, to undermine the sanctity of the capital structure and to treat differently stakeholders with similar legal rights. Indeed, seemingly attractive and politically expedient financial engineering, such as that used in the third Citigroup bail-out, risks undermining long-standing principles that have served the US well for years.

Finally, the US must never lose sight of the international dimensions of its policies. Its response must be consistent with efforts to upgrade a deeply challenged infrastructure for cross-border harmonisation of regulation and bank capital. The aim is to ensure a degree of global consistency that clarifies accountability and responsibility.

These are stringent requirements. Yet there is really no alternative. The US is already embarked on a journey to a “new normal” that includes reduced private credit intermediation and lower capacity for sustained, non-inflationary growth. Adherence to these five principles would help to ensure that the damage caused by past market failures is not compounded further by stress-test policy failures.

The writer is chief executive of Pimco and author of ‘When Markets Collide: Investment Strategies for the Age of Global Economic Change’, winner of the 2008 FT/Goldman Sachs Business Book of the Year

Copyright The Financial Times Limited 2009"

paying a 5 percent annual interest rate (via the preferred) in exchange for giving the government an explicit ownership stake (via the common)

TO BE NOTED: From TNR:

"Backdoor Nationalization? Maybe. But What's the Alternative?

I got into this a bit on CNBC last night (see below), but I figured I'd continue the debate off-camera, where I could have the final word.

The discussion centered around yesterday's New York Times piece reporting that Treasury may convert its stake in some of the major banks from preferred shares into common stock, which would basically free the banks from paying a 5 percent annual interest rate (via the preferred) in exchange for giving the government an explicit ownership stake (via the common).

Larry Kudlow and my two fellow guests argued that this was the culmination of Treasury's longstanding desire to nationalize the banks. The only real debate among them was whether Treasury was nationalizing through the back door or the front door.

My response was twofold. First, whatever you think about Geithner, it's safe to say his impulse is to avoid nationalization if possible. As I reported earlier this year:

Geithner and his colleagues are said to be deeply uncomfortable with the idea in principle. "Most people who run businesses in this area ... would look to nationalization as a last step--if it was the only thing standing between us and the abyss," says Michael Granoff, a private-equity fund manager who is friendly with several senior administration officials. "The people in charge of the economic policy side of things have pretty good communication with the people ... who sit where I sit," he says. "There is a shared understanding in these conversations."

This quote is hardly an outlier--I've had a number of well-positioned people tell me similar things.

Second, the relevant question isn't whether converting the preferred shares into common stock moves us closer to nationalization. It clearly does, if only very literally--in the sense that the government is gaining a more explicit ownership claim in the process. The question is closer relative to what. My sense is that Treasury is considering this step only in the case of banks that do poorly on the stress tests. Now, for such a bank, I can imagine three options other than the conversion that's on the table: One is to urge it to raise money from private investors, which seems extremely unlikely to happen. How attractive is a bank going to be when Treasury has effectively proclaimed it a stress-test flunkie (even if it doesn't quite put it that way). Option two is to inject more TARP money, which would presumably be in the form of equity, since Treasury apparently considers preferred shares to be debt and wouldn't want to increase the bank's debt burden. (And because additional injections of capital without giving taxpayers a share of the upside is probably tougher to justify politically these days.) Option three would be to seize the bank outright, FDIC-style.

So, of the three options other than conversion, the first is a non-starter and the second and third would mean an even bigger role for the government than conversion. If those are the relevant choices, it seems hard to interpret the conversion idea as a sign Treasury is bent on nationalization.

Having said all that, I admit there's something refreshing about debating Larry Kudlow on this stuff. He and I couldn't disagree more. But he's so upfront about his position--none of this mealy-mouthed hedging--that going at it with him turns out to be satisfying in a way it rarely is with people closer to me ideologically.

--Noam Scheiber"

further losses to debt holders of US banks will result in a boycott of US Treasury auctions

TO BE NOTED: From Via Naked Capitalism:

"Can Citigroup Be Restructured Without an FDIC Resolution?
April 17, 2009

text-to-speech MP3 audio version.

"In the modern world, science and society often interact in a perverse way. We live in a technological society, and technology causes political problems. The politicians and the public expect science to provide answers to the problems. Scientific experts are paid and encouraged to provide answers. The public does not have much use for a scientist who says, "Sorry, but we don't know". The public prefers to listen to scientists who give confident answers to questions and make confident predictions of what will happen as a result of human activities. So it happens that the experts who talk publicly about politically contentious questions tend to speak more clearly than they think. They make confident predictions about the future, and end up believing their own predictions. Their predictions become dogmas which they do not question. The public is led to believe that the fashionable scientific dogmas are true, and it may sometimes happen that they are wrong. That is why heretics who question the dogmas are needed." "The Need for Heretics"
Freeman Dyson

(Updated 4/20/09 to reflect FDIC response.)

First a final clarification about the Q4 2008 data from the FDIC. A reader of The IRA who is part of the regulatory community sends this comment regarding our last missive and our CNBC appearance on Tuesday with Dick Bove and Larry Kudlow. Says the reader: "Lots of Kool-Aid drinking going on out there with the financials. Your comment on the FDIC numbers is accurate, but does not go far enough. In the fourth quarter, WaMu's contribution to JPMorgan Chase (NYSE:JPM) should be fully reflected since WaMu got absorbed during the third quarter. In the fourth quarter, NatCity and Wachovia's income, expenses and charge-offs were reset to zero on the last day of the quarter, when they changed ownership as per pushdown accounting. So NatCity and Wachovia reported one day of income and expense results in their December 31 reports. Full year earnings numbers contained 95 days of WaMu (within JPM totals) and one day each of NatCity and Wachovia. All periods contained balance sheet amounts for WaMu, NatCity, and Wachovia. Those balance sheet amounts would have been affected by pushdown accounting, and in each case, since they changed control late in the quarter, we have no way of knowing how many non-performing loans they charged-off during the quarter in which they changed ownership. But these units all either filed their own Call/TFRs each quarter, or they were consolidated in the Call report of the institution that they were merged into. What is missing is the operating loss from WaMu during July, August & most of September; and operating losses from Wachovia and NatCity during most of Q4. In addition, the write-downs from purchase accounting did not get reflected in charge-offs, thus the US banking industry earnings and charge-offs for 2008 were way worse and will never be reflected in historical stats." So based on this input, if we consider the absence of data from WaMu, Wachovia and NatCity from the 2008 FDIC industry data, our guess is that instead of the profit of $10 billion in reported, the US banking industry in fact experienced a loss of at least that amount. Based on the anecdotal reports we have heard about Wachovia charge-offs, for example, the loss for the US banking industry in 2008 could be more than $25 billion. The only way we will ever know the truth is if the FDIC corrects the public record, again. We are going to be following up with a formal letter to the Board of the FDIC asking that they correct or at least footnote the incomplete information in the 2008 data for the US banking industry. If we can obtain the information above, informally, from FDIC officials, why is this data not part of the public record? In this way, investors, researchers and regulators will at least know what the true loss rate was for the US banking industry in 2008. Update: FDIC officials tell The IRA that their hands are essentially tied. First, the FDIC can only include in the record the data filed by institutions, so if the data is not actually in the call report, then the FDIC officials cannot report it. This "survivorship bias" has been in the data for some time, say FDIC officials, who add that this has always been the case but was made more pronounced by the adoption of purchase accounting in the mid-1990s. Finally, the FDIC notes that it did disclose that the industry would have been in loss but for the effects of purchase accounting, thus they feel that the public record is complete. Second, for users of the professional version of the IRA Bank Monitor, we have activated our beta test version of a new pro-forma tool to support bank M&A analytics. By specifying the RSSD IDs of two bank holding companies, the Bank Monitor will combine the balance sheets and income statements of the two entities into a pro-forma profile. Please contact us for additional information. Now on to the Zombie dance party, which is already in progress. Over the past several months we have been asserting that Citigroup (NYSE:C) is insolvent and needs to be either restructured or liquidated. Now that the Obama Administration has apparently decided to publicly list the results of the bank stress tests and since C is expected to be near the bottom of the list in terms of stress test results, the question comes whether the Obama Administration will move on resolving C before the May 4, 2009 released of the stress test results. We won't even refer to the Q1 results for C released this morning because, in our view, they really do not show the true condition of the bank nor the ultimate outcome that we expect to see with this institution. As of year-end 2008, C rated an "F" in the IRA Bank Monitor with a overall Stress Index score of 21 vs. the industry average of 1.8. As of the same date, JPM's Stress Index Score was 1.3. Unfortunately, it is becoming increasingly clear that the Obama Administration lacks the courage to resolve C. Economic policy guru Larry Summers reportedly bought the "systemic risk" argument hook, line and sinker, but the fact remains that with relatively healthy banks like JPM pricing debt at +350 to the curve, the real issue facing financials is not simply capital adequacy as the stress tests suppose, but rather the broader issue of credibility as going concerns. Even were JPM or Goldman Sachs (NYSE:GS) to actually redeem the preferred capital provided by the Treasury TARP program, none of these banks could survive today without government guarantees for their debt. One of the reasons that the Obama Administration provides for not taking action on C and other insolvent money center banks is that regulators lack the legal authority to act against a bank holding company (BHC) vs. the federally insured subsidiary banks. But this is not true. Federal regulators do have the power to compel management and board changes within BHCs. And they have two very powerful threats to use against officers and directors who do not take the "suggestion." First, the Fed and other regulators have the power to issue judicial orders and, more important, to commence enforcement actions against the officers and directors of a BHC. If you have never been the target of an enforcement litigation under Section 12 of the US Code, suffice to say that this makes civil litigation look tame. There is a rebuttable presumption of guilt and very serious civil penalties, including being barred for life as an office and director of a US financial institution. And by the way, the judges generally defer to the regulators. We cannot imagine an officer or director of C failing to resign if given the choice between a clean exit and several years of litigation with the OCC and Fed in front of an administrative law judge in Washington. And just for added weight, we can have President Obama make the call. Second and more important, the regulators have the ultimate threat of resolution, meaning the FDIC takes control of the subsidiary banks, bankruptcy for the parent holding company, years of civil litigation for the officers and directors, and also a possible enforcement action. Remember that when the FDIC takes over a bank and suffers a loss to the Deposit Insurance Fund, it files a claim against the bankruptcy estate of the parent BHC and can, if fraud or management malfeasance is suspected, begin an enforcement action against the officers and directors. With that background, it needs to said that the only thing standing between America and a solution to zombie banks is a lack of guts in Washington. We expect C to come it at or near the bottom of the 19 stress zombies next month. It also needs to be said that if there are not at least a few banks that "fail" the stress tests, then the process will be entirely incredible. Given this reality, how would we suggest dealing with C in such a way that minimizes the impact on the markets and the customers of C's subsidiary banks (remember C itself is a non-operating shell holding company)? We believe there is path other than FDIC resolution for the subsidiary banks and liquidation for C that may allow the company to address the issues of capital adequacy without C's bondholders taking a total loss and without the disruption to the markets that a traditional FDIC resolutions implies. Here in general terms is how we would address the issue: First, federal regulators need to impose immediate board and management changes at C. The new officers and directors should be selected based upon their willingness to take whatever steps are necessary to address the issue of capital adequacy of C's subsidiary banks, including the sale, restructuring and even liquidation of C in its entirety. This condition regarding the makeup of the new officers and directors is crucial to the success of what will be a voluntary restructuring process. Second, once a new management team and board are in place, then C must next formally contact the bond holders of C and invite them to form a creditors committee and enter into a negotiation to convert a significant portion of their debt into common equity. C has approximately $500 billion in long-term debt and another $400 billion in short-term debt. If roughly half of this $900 billion in debt was converted to common equity, then C's capital problems would be resolved without the need for an FDIC seizure of the group's banks, the need for further government assistance would be at an end, and more important, the bond holders would have a significantly higher probability of a recovery than in a traditional FDIC resolution. Indeed, part of the new capital proceeds from the conversion by bond holders could repay the C TARP investment in its entirety and without the need to go to the equity markets. Third and assuming that agreement could be reached with the bond holders, then C would approach regulators and formally request their support for a voluntary Chapter 11 filing by C, essentially a prepack restructuring under the FDIC's open bank assistance where the dominant creditors, namely the C bondholders, would support a petition by C management. The FDIC would also enter the bankruptcy as a creditor and assure the Bankruptcy Court that the FDIC was supporting the process and, most important, would not seize C's bank subsidiaries. The Fed and OCC would likewise support the process via official statements to the Bankruptcy Court. The prepack agreement between C management, the creditor committee and the FDIC would make the restructuring process fast, perhaps ending in less than a year if adverse litigation in bankruptcy is avoided. Suffice to say that with the bond holders, management and the FDIC all supporting the petition, it will be very difficult for other creditors to prevail - especially if the alternative is an FDIC resolution and a near-total loss for bond holders. To speed the decision process by bond holders, the FDIC could simply state that without full and unconditional agreement from all creditors, C will be resolved and the FDIC will commence an adverse litigation in bankrupty to recover all losses to the DIF, meaning a total loss to bond holders. Now you are probably wondering whether it is even possible for a BHC to file bankruptcy without immediately losing the control of the FDIC-insured banks. The answer is yes and the partial example is called MCorp, a Texas BHC that was forced into bankruptcy by creditors in 1989. Click here to read the FDIC study on MCorp, which was part of the Texas oil patch collapse and one of the most costly resolutions in FDIC history. But the cost to the FDIC of partially resolving the bank subs of MCorp pales in comparison to the current government assistance to C and other zombie banks. The MCorp case was complex and very contentious. The issues involved are very different from those facing C and other troubled money center banks, but the fact remains that while the OCC declared the subsidiary banks of MCorp insolvent, after cross litigation, MCorp was able to retain five bank subsidiaries with $3.2 billion in assets. These banks operated in bankruptcy while the parent was reorganized. Indeed, as the FDIC study notes, the success of MCorp in defeating seizure of the five subsidiary banks by the FDIC "led to the section of FIRREA that added provisions related to cross guarantees. The cross guarantee provision would be used most notably in the Bank of New England resolution." In the case of MCorp, had the cross-guarantee provisions that exist today been in effect, then the FDIC would have seized all of the MCorp banks and used those assets to reduce the loss to the Deposit Insurance Fund, as required by law. But with the case of C, the situation is the opposite, namely that by leaving C operating, albeit in bankruptcy and operating under "open bank" support, the FDIC, OCC and Fed can arguably make a case that this is the "least cost resolution" and also avoids systemic risk issues. Assuming that C's new management team and board is able to win the support of a) bond holders and b) regulators, then the way would be open to file a voluntary Chapter 11 petition and restructure C into a new format that aligns the interest of shareholders, the US government and the counterparties and customers of C's bank units. Specifically, once in bankruptcy, C should be restructured into a unitary national bank, with all of the subsidiaries of the group moved to beneath the lead bank, in this case Citibank NA. One of the evil side effects of the BHC structure that has been illustrated by the failures of WaMu and Lehman Brothers is the reality that the customers and counterparties of the bank subsidiary are actually senior to the debt holders of the parent BHC. This tension has caused a great deal of delay and confusion in moving forward with a solution to the solvency problems facing the large zombie banks. Foreign bond holders, like the government of China, have reportedly told the Obama Administration that further losses to debt holders of US banks will result in a boycott of US Treasury auctions. Not only would the unitary structure eliminate any conflict between creditors and customers, but it would also leave the Citibank NA unit as the top-tier, publicly listed company and the issuer of all of the remaining debt and equity. The restructured Citibank would have tangible common equity above 30% and half the debt it now supports. The BHC's interest expenses would fall dramatically and the excess capital would allow C management to quickly deal with all problem assets, sell operations and emerge from bankruptcy with a profitable, well capitalized bank. This outline does not address a number of technical issues related to the bankruptcy of a large BHC, but when you consider the alternatives - including the current approach of doing nothing being pushed on President Obama by Larry Summers, perhaps it is time to start thinking outside of the proverbial box. The US has already wasted months via inaction and political posturing. But if you understand that banks like C may very well be forced into a resolution before the end of 2009, perhaps it is time to start considering some creative alternatives before we are compelled, finally, to take effective action to start eliminating some zombies.

Questions? Comments? info@institutionalriskanalytics.com"

share prices are actually going up when convertibles are announced

TO BE NOTED: From Reuters:

"Will convertible-bond buyers help prevent bank nationalization?

Post a comment

Posted by: Felix Salmon

Tags: bailouts, banking

Edmund Andrews has the news that the Obama administration seems to have settled on its preferred method of recapitalizing banks which have failed its stress test: it’s going to take the TARP money that it’s already lent them, and convert it into equity. That makes perfect sense to me: it avoids the government having to ask Congress for extra funds, and it implies that banks will be nationalized to precisely the degree the government considers them to need its own recapitalization.

There will of course be one extra step in between. No bank can fail a stress test; instead, a preliminary stress test will reveal which banks require recapitalization. Then the banks will be given the opportunity to recapitalize themselves privately. If they can’t or won’t do that, then the government will step in with its debt-for-equity conversions.

And as far as that second step is concerned, it’s actually possible that there’s money out there now for banks willing to tap it. Richard Barley reports today on the revitalization of the convertible-bond sector, which is where most private-sector bank capital came from in the months immediately prior to the market shutting down completely:

Nomura said that before September 2008, 73% of its European trading in convertibles was with arbitrage-driven hedge funds. Now, 68% is with investors who buy the bonds outright. The global trend is similar, the bank said.

That change, combined with an investor focus on companies’ ability to refinance debt, means share prices are actually going up when convertibles are announced.

Steelmaker ArcelorMittal’s shares rose 7.6% when it sold a €1.1 billion ($1.45 billion) deal in March that was then increased to €1.25 billion…

Convertible investors are happy as prices are showing strong gains right after issuance, while traditional stock investors are getting a fillip as well. And investment banks are tapping into a fresh seam of fees.

Now banks, of course, aren’t steelmakers, and the fact that ArcelorMittal can successfully get a convertible away in Europe does not remotely mean that Bank of America, say, could manage to do one in the US. But BofA’s results this morning were solid, and bank stocks in general have been performing so well in recent weeks that there’s a reasonably large constituency of potential investors who might be interested in buying up some convertible bonds at attractive prices.

I’m just not completely convinced that the real-money market for convertible debt is as strong as Barley might like to think. If the hedge-fund bid disappears entirely, then of course the real-money investors will make up a higher proportion of the market. But that just means the market is a fraction of its former size. And what’s not obvious is that there are new real-money convertible-bond investors — people who might have been plain-vanilla equity investors in the past, but who now prefer the downside protection of a convert.

The fact is that convertible bonds are very scary things to most buy-siders: valuing them involves some pretty sophisticated option math, which is one reason why historically such bonds have been sold overwhelmingly to arbitrageurs. At the very least anybody buying a convertible bond should be able to work out the market price of trying to replicate it in the secondary market with a combination of debt and equity options, and should therefore be comfortable in the world of equity derivatives.

Are such people numerous enough to help recapitalize the entire US banking system? I’m sure that Treasury hopes so: the last thing it wants is to become the single largest shareholder in most of America’s biggest banks. But given how burned the last round of financial-institution convertible bond buyers ended up, I’m not holding my breath for a new set of investors to come galloping over the horizon on their white steeds, ready to save the government from being forced to implement its contingency plans."

Me:

“the last thing it wants is to become the single largest shareholder in most of America’s biggest banks”

1) It will if it has to:

http://www.nytimes.com/2009/04/20/busine ss/20trustees.html?ref=business

“The Treasury Department is poised to become Citigroup’s biggest shareholder, obtaining as much as 36 percent of its voting shares, and officials plan to turn over those shares to outside trustees as well. And if any of the 18 other large banks now undergoing government “stress tests” are told they need more capital, the government is likely to acquire more voting shares and turn them over to trustees, too.”

2) That chance is terrifying banks into making tough decisions:

http://www.nytimes.com/reuters/2009/04/2 0/business/business-banks-europe.html?re f=business

“That dilemma faces many banks. Dozens of lenders in Europe and the United States have been shored up with rescue funds from governments, but many are keen to limit their reliance on the state and selling profitable units is the most realistic alternative.”

- Posted by Don the libertarian Democrat Your comment is awaiting moderation.

The result was a plan to separate the ownership of A.I.G. shares, which lies with the Treasury, from the power to vote those shares.

TO BE NOTED: From the NY Times:

"3 Trustees of A.I.G. Are Quiet, Perhaps to a Fault

By EDMUND L. ANDREWS

WASHINGTON — In an early sign of just how tricky corporate governance has become in the era of taxpayer bailouts, three little-known trustees with no office, no staff and almost no mission will soon be deciding questions that affect the fate of American International Group, the giant insurance company.

The trustees include a retired Wall Street executive, the head of a Texas pipeline company and the chairwoman of a firm in Bermuda that provides administrative services to hedge funds.

Even though the government has bailed out A.I.G. with $170 billion in federal money, and even though the Treasury owns nearly 80 percent of its shares, the voting power is in the hands of the three trustees.

Yet for all their responsibility, the trustees have studiously remained invisible to the public. Even after the nationwide uproar last month over bonus payments made to A.I.G. executives at a time when taxpayers were rescuing the company from collapse, the trustees have said nothing in public about their activities or their plans.

The unusual arrangement will face its first test next month, when A.I.G. holds its annual shareholders meeting. Dissident shareholders, led by labor unions, are pushing for shareholder votes to oust an A.I.G. board member and to further restrict executive pay.

Fed and Treasury officials are likely to resist additional pay restrictions, fearing they would aggravate the exodus of crucial employees and make it even harder for A.I.G. to repay taxpayers. That could leave the trustees, who are each being paid $100,000 a year, in the awkward position of having to vote on a proposal that many taxpayers might support but that the government opposes.

The arrangement has raised questions about who really is in charge when the government bails out a major financial institution. Those questions could soon spread far beyond A.I.G.

The Treasury Department is poised to become Citigroup’s biggest shareholder, obtaining as much as 36 percent of its voting shares, and officials plan to turn over those shares to outside trustees as well. And if any of the 18 other large banks now undergoing government “stress tests” are told they need more capital, the government is likely to acquire more voting shares and turn them over to trustees, too.

Some analysts say the setup provides cover for officials who, despite the government’s large stake in various banks, want to preserve the notion that neither the Treasury nor the Fed “owns” A.I.G. or controls any major banks.

“This was the best idea they could come up with at 4 in the morning on how to avoid the conflicts of government ownership,” said Karen Shaw Petrou, president of Federal Financial Analytics, a consulting firm in Washington.

Their public debut at A.I.G.’s next shareholder meeting could also reinforce doubts that anybody — the government or the trustees — is really in control.

“If you own 77.9 percent of the shares, you’re an owner and you should act like an owner,” said Espen Eckbo, director of the Lindenauer Center for Corporate Governance at Dartmouth.

All three trustees were recruited by the New York Fed and have extensive business backgrounds.

One of them is Jill M. Considine, a former chief executive of the Depository Trust and Clearing Corporation and a former banking regulator, now chairwoman of the Butterfield Fulcrum Group in Bermuda, a firm that provides administrative support to hedge funds.

The two other trustees are Chester B. Feldberg, a former senior official at the New York Fed and a former chairman of Barclays Americas; and Douglas L. Foshee, the chief executive of the El Paso Corporation, a natural gas producer and pipeline operator.

The Treasury’s peculiar form of noncontrolling control over A.I.G. reflects a deeply rooted, bipartisan political aversion in Washington about “nationalizing” private enterprises, or having the government actively control them.

According to government documents, the trustees are legally independent of the Treasury and the Federal Reserve. They cannot be fired or replaced simply because their votes clash with the positions of policy makers.

And though they are not supposed to get involved in day-to-day management or set A.I.G.’s broad strategy, they have full power to vote the government shares. If they wanted to oust A.I.G.’s current board and chief executive, for example, they would have ample power to do so.

Citigroup agreed to a similar arrangement in January, when it reached an agreement with the government to convert its nonvoting preferred shares into shares of common stock. That conversion, which could occur as early as next month, would reduce Citigroup’s debt but give the Treasury 36 percent of the company’s voting shares.

The Treasury Department plans to put its Citigroup shares into a trust, just as at A.I.G., and turn over the voting power to little-known trustees.

Similarly, Treasury and Fed officials later are expected to push several of the 19 largest banks now undergoing special examinations to raise more capital by converting their existing government loans into common stock with full voting rights.

In any other country, such moves would add up to at least a partial nationalization of major financial institutions. But nationalization remains so politically explosive in the United States that President Obama and his top advisers are straining to avoid the slightest hint of it.

Officials who helped draw up the plan for A.I.G. said their main goal was a practical one: how to avoid conflicts of interest between the government’s role in setting broad policy and its role as a corporate shareholder.

“It wasn’t about ideology and it wasn’t about philosophy. It was about crisis management,” said Thomas C. Baxter Jr., general counsel for the Federal Reserve Bank of New York, which engineered much of the A.I.G. bailout last September. “We were at a very fragile point, and we had to come up with a decision right away about how to deal with the hand we had been dealt.”

The result was a plan to separate the ownership of A.I.G. shares, which lies with the Treasury, from the power to vote those shares.

Mr. Baxter said the closest thing to a precedent arose during the collapse in 1991 of the scandal-ridden Bank of Credit and Commerce International. In that case, bank regulators created a trust to separate the bank from First American Corporation, a holding company that B.C.C.I. had secretly controlled and that the government wanted to sell.

In the case of A.I.G., the trustees’ silence has frustrated the company’s critics.

“If this is going to be the model going forward, taxpayers and other investors have a right to understand how this trust arrangement is going to operate,” said Richard C. Ferlauto, a lawyer representing labor unions that called for the ouster of an A.I.G. board member, James F. Orr III, who was chairman of the committee that approved the bonus plan. The unions received no response from the trustees.

“It’s absolutely essential that the trustees flex their ownership rights,” Mr. Ferlauto added.

Thus far, the trustees have not set up an office or hired any full-time staff. A lawyer at Arnold & Porter, Kevin F. Barnard, advises them on legal issues. This month, the trustees hired a part-time spokesman to field questions from the news media.

And what have the trustees been doing?

“The trustees meet once a month in person and have a standing weekly conference call,” the spokesman, Peter Bakstansky, wrote in response to an inquiry. The group is also meeting with A.I.G. executives and government officials, he continued. “And yes, there have been more meetings recently, many in the context of the upcoming A.I.G. shareholders meeting.“

restore status quo ante and not deal with any remedies that might prove inconvenient to the moneyed classes.

From Naked Capitalism:

"US to Impose Conditions on TARP Repayment

The Administration is trying to look like it is not rolling over to banks' demands on the issue of repayment of TARP money. But despite the tough-ish talk, the problem described by John Gapper remains. Whether the bank pay back the TARP or not, they and the wider world clearly know that they will not be permitted to fail, at least in their current (big and interconnected) incarnations. That in turn means they should be kept on a short leash until industry reforms and/or restructuring has taken place, since they are in effect gambling with house money, no matter what the formal balance sheet arrangements are. Keeping them in TARP is one way of addressing this conundrum; imposing other sorts of interim restrictions on "too big to fail" concerns is another approach. But Team Obama seems determined to try to restore status quo ante and not deal with any remedies that might prove inconvenient to the moneyed classes.

From the Financial Times:

Strong banks will be allowed to repay bail-out funds they received from the US government but only if such a move passes a test to determine whether it is in the national economic interest, a senior administration official has told the Financial Times.

“Our general objective is going to be what is good for the system,” the senior official said. “We want the system to have enough capital.”

Yves here. Note the turn of phrase? This crowd is fond of tests as being objective measures, when in fact they are being run by the industry on data not independently verified, through risk models shown to be unreliable in the face of extreme events. And first the official talks of "national interests" and sees that as tantamount to "what is good for the system". That line of reasoning conveniently ignores the problem that the system we have in place, per Simon Johnson, may be diametrically opposed to our collective best interest. Back to the article:

On Sunday, Lawrence Summers, President Barack Obama’s top economic adviser, told NBC’s Meet the Press that repayments could eventually help the government provide further resources to help the sector. Such a move could also allow healthier institutions to differentiate themselves from weaker banks and free them from constraints on executive pay, and other activities, that come with bail-out money.

Yves here. Again, ideology rampant. Being "free from constraints" is seen as being aligned with the general good, when pretty much everybody except the banksters and their buddies at the Fed and Treasury think more regulation is in order. To the FT;

“Not surprisingly different banks are in different situations; they are going need different levels of assistance of taxpayers,” Mr Obama told a press conference at a summit in Trinidad on Sunday, while promising: “I’m not going to simply put taxpayer money into a black hole.”

Yves here. Ooh, and pray tell what is AIG? Oh, because it is not a bank, merely a back channel to recapitalize bank, it's exempt from the black hole consideration. Back to the article:

The official, meanwhile, said banks that had plenty of capital and had demonstrated an ability to raise fresh capital from the market should in principle be able to repay government funds. But the judgment would be made in the context of the wider economic interest. He said the government had three basic tests. It needed first to “make sure the system is stable”. Second, to not create “incentives for more deleveraging which would deepen the recession”. Third, to make sure the system had enough capital to “provide credit to support the recovery”.

Yves again. The banks are ALREADY adding to pressures to delever by cutting consumer credit lines, In fact, if you buy Tyler Durden, banks are squeezing shorts by cutting credit even further to prime brokers, which is leading to less stock market liquidity and makes it (and other markets) more vulnerable to downturns. One of the big impetuses to goose the market would be for banks like Goldman to sell stock at more favorable prices to get out of the TARP. So if you buy argument #2, you wouldn't let any bank who is a major prime broker (Goldman, Morgan Stanley, JP Morgan) pay back TARP proceeds,

And how much capital is needed to provide for recovery very much depends on your view of the future of securitization. Right now, it's on government life support. Without fundamental reform, that market will not come back in a meaningful way (at least until the lessons of this disaster are forgotten and people make the same mistakes all over again). And the economics will not be anywhere near as favorable under a new regime that fixed incentives properly. For instance, requiring banks to hold enough of the paper they originate would increase costs and require better capitalized intermediaries all along the food chain. And even that didn't succeed last go round; recall Merrill held a lot of the risky late vintage CDOs on its books when the market turned.

If the private securitization market does not come back in a meaningful way, that means either phony government diddled credit markets indefinitely, or vastly bigger balances sheets in the financial sector, since banks will originate and hold loans (probably trading some loans among themselves to create better diversification). That too argues against returning TARP funds.

More on this topic (What's this?)

Warren Interview: Wall Street’s “system has collapsed” (Option ARMageddon, 4/12/09)

TARP Has Lost 40% Since Inception (Zero Hedge, 3/9/09)

Genworth Fails To Qualify For TARP, Shares Plunge (Zero Hedge, 4/9/09)

Read more on Troubled Assets Relief Program (TARP) at Wikinvest

Posted by Yves Smith"

Me:

Don said...

I'm having a hard time understanding what people are proposing. I do not believe that we can seize the banks at the present time. It would certainly be a mess. I guess if you believe that we can, all this seems silly to you. I too would rather have an FDIC seizure, but I don't see how this can be done with creating an enhanced FDIC or new agency, like the RTC, first.

If you can't do that, I'm assuming that people want us to get stock from the banks and, possibly, even get controlling interest in the banks. That has problems like the following:

http://www.nytimes.com/2009/04/20/business/20bailout.html

"The Treasury would also become a major shareholder, and perhaps even the controlling shareholder, in some financial institutions. That could lead to increasingly difficult conflicts of interest for the government, as policy makers juggle broad economic objectives with the narrower responsibility to maximize the value of their bank shares on behalf of taxpayers.

Those are exactly the kinds of conflicts that Treasury and Fed officials were trying to avoid when they first began injecting capital into banks last fall. "

And:

"Each conversion of this type would force the administration to decide how to handle its considerable voting rights on a bank’s board.

Taxpayers would also be taking on more risk, because there is no way to know what the common shares might be worth when it comes time for the government to sell them."

In other words, as I said, all the hybrid problems would remain, and the international problems would be worse.

Finally, Stiglitz said the following:

"Rather than continually buying small stakes in banks, weaker banks should be put through a receivership where the shareholders of the banks are wiped out and the bondholders become the shareholders, using taxpayer money to keep the institutions functioning, he said....

“You’re really bailing out the shareholders and the bondholders,” he said. “Some of the people likely to be involved in this, like Pimco, are big bondholders,” he said...."

Legally, I'm not sure what he's proposing, but the largest holders of these bonds, as I've pointed out before, are:

1) Pensions
2) Insurers
3) Foreign Governments
4) Foreign Investors

1 and 2 are bailouts waiting to happen, and 3 and 4 are very bad news going forward.

As Inner Workings has pointed out:

http://blog.atimes.net/?p=901

"Reminder: why the Treasury needs the banks to look better
April 14th, 2009
By David Goldman

The next sector to collapse would be the insurers: as I’ve said here again and again, the big pyramid scheme in the US financial system is that the insurers own the bottom of the capital structure of the banks. Bank preferreds, trust preferreds, hybrids, etc. were the favorite repast of yield-hungry insurance portfolio managers.

The big insurance companies all are trading like junk, still. Here is the cost of five-year credit protection on two of the biggest:

It’s cheaper to refloat the banks than to go in and bail out insurers after public confidence collapses."

All the recent stories about pensions, insurers, and annoyance with the dollar are related to this. I'm just having a hard time understanding what some people are actually proposing.

Don the libertarian Democrat

April 19, 2009 11:51 PM

juggle broad economic objectives with the narrower responsibility to maximize the value of their bank shares on behalf of taxpayer

TO BE NOTED: From the NY Times:

"U.S. May Convert Banks’ Bailouts to Equity Share

By EDMUND L. ANDREWS

WASHINGTON — President Obama’s top economic advisers have determined that they can shore up the nation’s banking system without having to ask Congress for more money any time soon, according to administration officials.

In a significant shift, White House and Treasury Department officials now say they can stretch what is left of the $700 billion financial bailout fund further than they had expected a few months ago, simply by converting the government’s existing loans to the nation’s 19 biggest banks into common stock.

Converting those loans to common shares would turn the federal aid into available capital for a bank — and give the government a large ownership stake in return.

While the option appears to be a quick and easy way to avoid a confrontation with Congressional leaders wary of putting more money into the banks, some critics would consider it a back door to nationalization, since the government could become the largest shareholder in several banks.

The Treasury has already negotiated this kind of conversion with Citigroup and has said it would consider doing the same with other banks, as needed. But now the administration seems convinced that this maneuver can be used to make up for any shortfall in capital that the big banks confront in the near term.

Each conversion of this type would force the administration to decide how to handle its considerable voting rights on a bank’s board. Taxpayers would also be taking on more risk, because there is no way to know what the common shares might be worth when it comes time for the government to sell them.

Treasury officials estimate that they will have about $135 billion left after they follow through on all the loans that have already been announced. But the nation’s banks are believed to need far more than that to maintain enough capital to absorb all their losses from soured mortgages and other loan defaults.

In his budget proposal for next year, Mr. Obama included $250 billion in additional spending to prop up the financial system. Because of the way the government accounts for such spending, the budget actually indicated that Mr. Obama might ask Congress for as much as $750 billion.

The most immediate expense will come in the next several weeks, when federal bank regulators complete “stress tests” on the nation’s 19 biggest banks. The tests are expected to show that at least several major institutions, probably including Bank of America, need to increase their capital cushions by billions of dollars each.

The change to common stock would not require the government to contribute any additional cash, but it could increase the capital of big banks by more than $100 billion.

The White House chief of staff, Rahm Emanuel, alluded to the strategy on Sunday in an interview on the ABC program “This Week.” Mr. Emanuel asserted that the government had enough money to shore up the 19 banks without asking for more.

“We believe we have those resources available in the government as the final backstop to make sure that the 19 are financially viable and effective,” Mr. Emanuel said. “If they need capital, we have that capacity.”

If that calculation is correct, Mr. Obama would gain important political maneuvering room because Democratic leaders in Congress have warned that they cannot possibly muster enough votes any time soon in support of spending more money to bail out some of the same financial institutions whose aggressive lending precipitated the financial crisis.

The administration said in January that it would alter its arrangement with Citigroup by converting up to $25 billion of preferred stock, which is like a loan, to common stock, which represents equity.

After the conversion, the Treasury would end up with about 36 percent of Citigroup’s common shares, which come with full voting rights. That would make the government Citigroup’s biggest shareholder, effectively nudging the government one step closer to nationalizing a major bank.

Nationalization, or even just the hint of nationalization, is a politically explosive step that White House and Treasury officials have fought hard to avoid.

Administration officials acknowledged that they might still have to ask Congress for extra money. Beyond the 19 big banks, which are defined as those with more than $100 billion in assets, the Treasury has also injected capital into hundreds of regional and community banks and may need to provide more money before the financial crisis is over.

Treasury officials say they have more money left in the rescue fund than might be apparent. Officials estimate that the fund will have about $134.5 billion left after the Treasury completes its $100 billion plan to buy toxic assets from banks and after it uses $50 billion to help homeowners avoid foreclosure.

In practice, the toxic-asset programs are not expected to start for another few months, and it could be more than a year before the Treasury uses up the entire $100 billion. Likewise, it will be at least a year before the Treasury uses up all the money budgeted for homeowners.

But the biggest way to stretch funds could be to convert preferred shares to common stock, a strategy that the government seems prepared to use on a case-by-case basis.

Ever since the Treasury agreed to restructure Citigroup’s loans, officials have made it clear that other banks could follow suit and convert their government loans to voting shares of common stock as well.

In the stress tests now under way, regulators are examining whether the big banks would have enough capital to withstand an economic downturn in which unemployment climbs to 10 percent and housing prices fall much further than they already have.

As their yardstick, regulators are expected to examine a measure of bank capital called “tangible common equity.” By that measure of capital, every dollar a bank converts from preferred to common shares becomes an additional dollar of capital.

The 19 big banks have received more than $140 billion from the Treasury’s financial rescue fund, and all of that has been in exchange for nonvoting preferred shares that pay an annual interest rate of about 5 percent.

If all the banks that are found to have a capital shortfall fill that gap by converting their shares, rather than by obtaining more cash, the Treasury could stretch its dwindling rescue fund by more than $100 billion.

The Treasury would also become a major shareholder, and perhaps even the controlling shareholder, in some financial institutions. That could lead to increasingly difficult conflicts of interest for the government, as policy makers juggle broad economic objectives with the narrower responsibility to maximize the value of their bank shares on behalf of taxpayers.

Those are exactly the kinds of conflicts that Treasury and Fed officials were trying to avoid when they first began injecting capital into banks last fall."

“There will be some subsidy. There probably has to be,”

TO BE NOTED: From the FT:

"Steeled for stress

By Krishna Guha

Published: April 19 2009 20:05 | Last updated: April 19 2009 20:05

Pictured above: the Universal testing machine, then the world’s biggest, snaps a steel bar in 1955. Now, US financial groups are undergoing checks – but are those of similar rigour?

For US banks, it is shaping up as something akin to a giant system-wide rights issue. Acting as underwriter and facilitator: the administration of President Barack Obama.

As early as this week, US regulators will start discussing with bank executives the outcome of “stress tests” they have carried out in an attempt to determine how much capital each of the top 19 banks would need comfortably to survive a deeper-than-expected recession. The tests have involved exhaustive analysis of bank assets over many weeks, during which investors and creditors have been left dangling in uncertainty.

The fate of the whole Washington plan will go a long way towards determining whether – as Tim Geithner, Treasury secretary, and other top officials believe – the banks can be restored to health without first being taken under control through nationalisation or bankruptcy.

Below: Taxpayers’ curse

What is therefore the likely upshot? People involved in the process say the mission has generated a wealth of information, collected on a standardised basis that allows one bank to be compared to another better than before. But in each case, the bottom line will be a number: the amount of additional equity that regulators want each bank to raise in order to meet the stress-test standard.

Implicit in this number will be the answer to both a total capital test and a quality of capital test – the authorities want banks both to be well-capitalised and to have most of their core capital in the form of common equity rather than other instruments. Banks will be given six months to raise the equity they need from private investors – or they will have to accept government securities that convert into equity as needed to replenish losses but also give the government partial ownership of the bank.

Meanwhile, the authorities will roll out public-private partnerships to buy from banks their toxic securities and loans – now neatly rebranded as “legacy assets”. The controversial partnerships (see below) will bring new liquidity to the market for toxic assets, raising their price to levels more commensurate with their cash-flow value – or beyond, if critics are right.

Policymakers envisage banks using these marketplaces to clean up their balance sheets – some voluntarily, to attract private capital and avoid government equity, and some as a condition of government-backed restructuring. At the same time, they are relying on banks’ ability to generate large profits in markets with high spreads and limited competition to help offset losses on bubble-era assets. The concept is of a process rather than an event, with different elements working to facilitate bank restructuring and recapitalisation. That reflects policymakers’ belief that there is no silver bullet.

Top officials see the plan as a distinctive solution that draws on lessons from past crises in Sweden and Japan as well as from the collapses some 20 years ago among US savings and loans associations. But it differs from those approaches because of the complexity of the modern financial system – and the decision to intervene earlier in the crisis, they maintain. “There is no precedent for it,” says a senior administration official.

He says that in past crises, policymakers waited for at least three or four years before intervening, by which time it was clear that non-performing loans had wiped out bank capital. Deciding what to do in such situations, he adds, is “a simple problem relative to what we are doing” – which is to try to restore the financial system to health at a stage at which it is not bankrupt and might never be.

The senior official says the capital need in the US is “modest relative to past historical experience” and compares favourably to other countries as a proportion of gross domestic product. Still, he admits, it does exist. “There is a gap in some parts of the system and we believe it is better for that gap to be filled earlier rather than wait to see if the bad outcome materialises,” he says. The stress tests will, in theory, both measure the size of the hole and locate where it lies.

Analysts highlight a number of specific concerns about the plan. The moment of disclosure of bank capital needs is fraught with danger for weaker banks; the government – which by its own accounting has only $135bn (€103bn, £91bn) in bail-out funds left – may not be able to fill the true gap if private capital is not forthcoming; and the private sector is fearful of engaging with the government amid a populist backlash against Wall Street.

Policymakers acknowledge that the plan breaks from the “convoy” system of recapitalisation put in place last October by Hank Paulson, Mr Geithner’s predecessor under George W. Bush, at the height of the panic. They say it is better to clear the cloud of uncertainty and allow stronger banks to raise capital from the market than to leave all of them unable to do so. “The market is differentiating more now anyway,” says the senior official. “What we want is for the differentiation to be based on knowledge rather than some big uncertainty.”

He says banks that demonstrate abundant capital and an ability to raise fresh equity should, in principle, be able to repay existing government preferred shares – a prospect that worries weaker competitors. But the assessment would be based on “what is good for the system”.

The senior official plays down concerns about the limited amount of additional government funds to backstop the capital raising – though few political analysts doubt the administration would ask for more money if the political window opens. “There are lots of sources of capital,” the official says. “You can raise more capital from the market, you can take your existing preferred stock from the government and convert it, you can convert other preferred, you can take more capital from the government.”

The big challenge, though, comes from critics who question the entire premise of the administration’s approach: the idea that it is intervening early enough in the crisis to fix the system without having to nationalise or bankrupt the banks and divide them into so-called “good” and “bad” banks along the lines of the Swedish model.

Describing that notion as a “fundamental misconception”, Simon Johnson, a professor at MIT and former chief economist at the International Monetary Fund, says: “The nature of the system has changed. Things that used to happen in 10 years, happen in 10 days or even 10 minutes.”

Kenneth Rogoff, a professor at Harvard and another ex-IMF chief economist, thinks it is absurd to say the banking system is not truly impaired today, when it is being kept alive by government funding guarantees, liquidity support from the Federal Reserve and a host of other props. Even the banks’ ability to generate large profits is based in part on their undertaking proprietary trading with Fed loans and implicit government guarantees against failure, he argues. “This is a policy of forbearance that could easily make the crisis last longer.”

Critics charge that the stress tests are just not stressful enough – that they are inadequate to prepare banks against a wide range of eventualities and thereby restore confidence in them.

Nouriel Roubini, chairman of RGE Monitor, points out that US unemployment, at 8.5 per cent, is on track to exceed the stress case scenario. More­over, banks are asked to estimate losses on loans under this scenario only over two years – up from the usual one, but not covering the full lifetime of the loans.

Policymakers say the microeconomic assumptions are tough and warn against writing off the tests as a whitewash before these details are made public. Examiners, for instance, are asking banks to estimate what the appropriate level of reserves might be at the end of the two-year period – implicitly taking into account lifetime losses to some degree.

Officials are also considering adjusting for the faster-than-expected rise in unemployment by requiring banks to hold more equity than they would otherwise have done for any given set of stress-test findings.

Yet some policymakers admit that this is not a textbook “truth-telling” exercise in which banks are forced to write down assets to a worst-case value and then be recapitalised on that basis – a version of which is widely credited for catalysing the final recovery from crisis in Japan. It remains within the confines of a conventional form of bank accounting that some economists – and some policymakers – think provides a flawed picture of solvency.

However, even policymakers who dislike bank accounting believe that the US is a society of laws, and that the government cannot simply decide that it thinks banks are bankrupt and seize them. Officials think the capital increase determined by the stress tests will significantly strengthen the system, even if it is not enough to guard banks against a very wide range of plausible outcomes.

In addition, officials see the tests as having generated a lot of useful information and are pressing for this to be disclosed to the public, allowing for an informed discussion about bank solvency under different assumptions.

Policymakers are loath to amputate when they might be able to nurse a limb back to health. Some think in terms of reversible error – preferring to take steps that can be revised later if necessary – and there is a general aversion to taking high-risk steps that could do more harm than good. “Governments should practise the same principles as doctors – first, do no harm,” said Mr Obama this month, rejecting pre-emptive government takeovers that could threaten confidence.

An important feature of many policymakers’ thinking is that this is not their last shot – that they are still early enough in the life of the crisis to come back and try again with other, more forceful measures if it does not work.

Still, the administration’s capacity to muster what it takes to intervene decisively could diminish over time. At MIT, Prof Johnson says the politics of bail-outs could get worse rather than better, while Mr Obama’s approval ratings could diminish.

Yet even critics think the administration may get lucky and do just enough to allow the US to muddle through. The banking system has come back from the brink before – for instance in the early 1980s.

“It could all work out – who knows?” says Prof Rogoff. “But there is certainly a chance that what they are doing will end up costing more and prolonging the recession.”

Taxpayers’ curse may be to subsidise those who sell the toxic assets

Is the Obama administration’s plan to create a market for toxic “legacy assets” a scam designed to funnel large taxpayer subsidies to banks? Though the administration rejects the charge, many prominent economists say that is just what it is.

Jeffrey Sachs, a professor at Columbia, says the plan is a “thinly veiled attempt to transfer up to hundreds of billions of dollars of US taxpayer funds to the commercial banks by buying toxic assets from the banks at far above their market value”.

The argument is that by providing non-recourse loans to finance most of the private-public purchases, the government will give its partners a strong incentive to overbid for assets of uncertain value.

This is because the private investor will share much of the profit if the asset turns out to be valuable but only a small share of the loss if it turns out to be worthless. The non-recourse loan in effect constitutes a “put option” or loss-limiting guarantee for the private partner.

Peyton Young, a professor at Oxford, says the auctions of toxic assets will ensure buyers pass on the subsidy to sellers – mostly banks. He calls this the “taxpayers’ curse”. Roger Farmer, a professor at UCLA, says the plan “will result in a subsidy to the unsecured creditors of the banks and will rightly be perceived as unfair”.

Critics are particularly troubled by provisions that would allow banks to buy each others’ toxic assets using the non-recourse loans. This could magnify overpayment problems and would shuffle assets around the banks rather than shifting them to other parts of the financial system where they may have less bearing on credit flows.

Even those who favour allowing banks to buy each others’ assets with non-recourse funds, such as Ricardo Caballero, a professor at MIT, say this amounts to providing insurance-style “guarantees” on bank portfolios.

Policymakers insist they are not trying to recapitalise banks by the back door. They say they are simply trying to eliminate the liquidity risk premium currently weighing on the assets. Pools of assets are always financed by non-recourse loans that embed a put option, they add. All they are doing is providing financing on terms the market would normally offer but will not during a crisis – an extension of traditional lender-of-last-resort activity.

Critics have jumped the gun in alleging big subsidies, they add, since they have not yet disclosed the terms on their loans.

Michael Spence, a professor at Stanford, says the loans do not represent a subsidy if the government recoups the value of the put option embedded in them, for instance through warrants. The option value depends on how uncertain the value of an impaired asset remains.

“Government therefore needs to confine the use and match the level of leverage to cases in which the value may be impaired but the uncertainty is low to moderate,” says Prof Spence

Most defenders of the plan expect there will be some subsidy, but less than the critics allege, and that it will be money well spent. Indeed, there may need to be a subsidy to persuade banks to sell.

Banks that are borderline insolvent will not sell volatile assets even at their full expected cash-flow value, because of the incentives created by limited liability banking. Their shareholders benefit if the assets turn out to be valuable but have little to lose if they turn out to be worthless. They would have to be paid a premium to part with this volatility.

“There will be some subsidy. There probably has to be,” says a non-US official. “The question is whether the plan is efficiently designed to pay only the minimum subsidy necessary.”

Copyright The Financial Times Limited 2009"