Preferred Stock and Subordinated Debt

Adam Levitin of Credit Slips:

Preferred Stock=Subordinated Debt, by Adam Levitin: The important thing to notice about the Treasury's "equity" injection into major financial institutions is that it is equity in name only. The preferred stock the Treasury is taking is at a prescribed dividend (5% for 5 years, 9% thereafter) and has no voting rights. Economically, it is a subordinated loan without a term.

A few observations come out of this. First, is that it means that Treasury has very little economic upside. No matter how well the banks perform, the best that Treasury can do is get a 5% return. True, the Treasury will get warrants ... which gives it some upside, but that is only for around 13% of the deal; the other 87% of the deal has no upside. Also, Warren Buffet was able to get 10% from Goldman Sachs. Why isn't Treasury getting the same deal? (And how fast do you think Goldman will use 5% Treasury dollars to buy back Buffett's 10% stock...?)

Second, by making an economic loan, but doing it in the form of preferred stock, Treasury has functionally subordinated itself to the bondholders and other debt obligations of the banks. That is a HUGE boon for the bondholders, because it functions a lot like a government guarantee of their positions. It also benefits the common shareholders by making sure that they won't be taken to the cleaners like WaMu and Lehman shareholders.

Third, as has been noted elsewhere, Treasury didn't forbid the financial institutions from paying dividends on the common stock, only from raising the dividends. So formerly cash strapped institutions are going to be able to keep paying out dividends...from taxpayer funds.

So why did Treasury do the deal as preferred stock?

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

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

This would explain why the deal provides for a five year term for the cumulative 5% preferred stock to bank holding companies and the non-cumulative nature of the 5% preferred stock to be issued by banks that are not part of bank holding company structures. ...

For a bank holding company, a minority interest (like the government's) related to qualifying cumulative perpetual preferred stock directly issued by a consolidated U.S. depository institution ... counts as restricted Tier 1 capital. ... For a national bank, however, noncumulative perpetual preferred stock is counts as Tier 1 capital. ... So for the holding companies, it is OK that the preferred is cumulative, while for the preferred issued by banks outside of holding company structures, the preferred must be noncumulative. Moreover, for bank holding companies to have cumulative preferred qualify as Tier 1, it must not have a 5 year minimum deferral period before default.

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

Comments

[Bruce Wilder]

Considering that the banks still have, roughly $600 billion in losses to realize, this seems like an ill-considered effort to protect stockholders and bondholders. No effective limit of stockholder dividends, no dilution of existing stockholders, no effective constraints on executive compensation, and no upside to the government to compensate for losses.

I am equally suspicious of assigning Fannie and Freddie to buy up toxic assets, outside the $700 billion appropriated by Congress. Is this a poison pill to Fannie and Freddie, to ensure they cannot survive?

[Arun Garg]

Since banks typically can lend 10x of their equity, does it not imply that injecting $250B as equity will potentially facilitate $2.5 trillion in new lending? It appears to me that this is significantly better that a $250B loan.

[Bj Feng]

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

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

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

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

[BJ Feng]

Arun, you are right, the bank, thanks to capital requirement regulations, are limited to the amount of loans they can make. It all depends on how much capital they have. So a loan from the government rather than a capital infusion would be of limited use if the goal is getting banks to lend more. Banks could be unwilling to lend if they expect more losses in the future that will erode their capital base. They know they can only loan out X times their capital, so if they are going to take more losses, they must reduce their loans outstanding. A capital infusion allows the bank to absorb more losses while also making additional loans.

[BJ Feng]

Let me restate my previous comments. Yes the government is only getting limited upside through warrants, but you cannot make them pay more than they are capable of or else they will fail under the burden of the payments to government. If we think banks will have to take more losses in the future, then making them pay 10% interest dooms them. There is no loan out there that banks can make 10% on, without taking a huge amount of risk! Buffet got his good deal because Goldman and others hoped that his investment would encourage others to invest with worse terms. So he was paid a premium as an advertisement to the rest of the world. His stamp of approval cost that much, Goldman cannot afford the same terms for everyone.

You also cannot wipe out existing shareholders and bondholders without a good reason, like the bank is insolvent. If there is anything left, there is no justification for government to take that away. Under bankruptcy, the bond holders are entitled to the assets, and the shareholders whatever is left.

If you are going to wipe out shareholders and bondholders, then why bother making this transaction? Why not create a new bank and allow the old one to fail? If the purpose is to prevent the bank from failing, then you cannot punish shareholders and bondholders beyond a certain point. This is especially true with bondholders which get the assets in a failure. As for common shareholders, they only get what is left after the government gets the dividend from the preferreds, their future profits are diluted, not to mention the warrants. And as I noted before, you can only ask the bank to cough up so much in dividends and interest before it becomes impossible for the bank to continue. A bank dies when its cost of funding becomes larger than the profit it can make from operations. A very high dividend rate on the preferreds and the bank cannot make money and is guaranteed to fail. People aren't stupid, if they calculate and see that there is no way for a bank to make that much to pay the government, they will start selling and we'll have a rout.

says...

If the loan can be counted as regulatory capital it's the same economically, leverage effects and all.

[Ryberg]

"I’ve never fully understood why an equity stake is better/different than a loan at a penalty rate"

This is a serious admission. The differences are fundamental to a capitalist economy. In simple terms, there can be gains and loses "on" and "of" investments. A bond investor is given a promise "of" both principle and interest "on" principle over a defined time period. Common stock equity has no promise "of" principle or dividends "on" principle over any time period. However, the equity owner gets two things the bond owner does not get: residual profits (if any) and business control. Hard as it may be for economists to understand, some consider control to be more important than profits.

In practice, control is an illusive concept but hotly contested. Fixed income investors can set conditions on their investments which limit management control. Some preferred equity investors seek more predictable returns in exchange for giving up operational control. But they can retain policy controls, if they have voting authority.

Or they can give up policy goals in exchange for political goals! Paulson and TARP are only incidentally seeking returns "on" or "of" their investments. It is largely window dressing. They will not lose their jobs or have to pay any penalties if their efforts fail. But their friends will be able to retain their jobs and have the prospect of potential profits if they succeed. By using preferred equity without voting rights, bond investors will have improved possibilities of returns "on" and "of" their investments and common stock holders will have improved potential profit returns. Wall Street should be happy.

But this is still lipstick on a pig. Bad debts were created and then creatively hidden. Enron-like accounting converted increased debt into "recognized" income and profits. Now this debt must be decreased by recognizing losses to profits and equity.

TARP investments may preserve capital requirements so existing management (or a close proximity) may continue to control the bank or financial institution. But no amount of investment can prevent bad debt from being written off. Although it could be hidden by putting it onto the government's balance sheet where it would be ignored by almost everyone except the future generations.

[Mark Thoma]

That's not what I meant by that statement, obviously I know how stocks and bonds differ (and the difference in risk I referred to is just another way of saying the same thing, I figured that was obvious).

[Note/Update: The first part of the post was being misinterpreted, I wasn't clear, so I removed it. What's left makes the same points.]

[Robinia]

Thanks so much for posting this-- I was trying to understand exactly what the details of the equity injection were. Still seems to me to let the IB insiders off too easily at the expense of our children. Now, alas, I know how in more detail. The wrong people are in charge; there must be a change-out, both at Treasury and on Wall St. Control must be transitioned, whether ideology encourages it or not.

[High Yield]

"...5% for 5 years, 9% thereafter..."

From an investor's perspective, high yield junk bonds. The banks may have to leverage operations quite a bit to earn enough on the spread between deposits/loans to pay 9%. Since loan rates are subsidized at low levels, deposit rates are likely to go even more negative than they already are, discouraging depositors. This will lead to even more dependence upon marketing securitized loans overseas as the primary profit engine. In light of the current reputation of domestic loan brokers overseas, this may require public guarantees of most future brokered low rate loans to make it work.

[swells]

This post is spot on. When I finally got a look at how it is being done, it became clear to me that many more loss realizations are on the way. I think that is the central fact to take away here. It is anticipated that these banks will have losses that require the Tier 1 capital designation for the government infusion to stay solvent. The leveraging that is possible off tier 1 capital gives some upper estimate on the size of the losses anticipated in my view.

[anne]

Mark Thoma:

"Note/Update: The first part of the post was being misinterpreted, I wasn't clear, so I removed it. What's left makes the same points."

Darn; I thought the writing was clear and the varying wording helped clarify the entire post and I wish the post could be restored precisely for the helpful paraphrasing.

[robertdfeinman]

Apparently investors aren't being persuaded by Bailout version III.

For example: a Citi, exchange traded preferred is selling at $14.25 for a $25 par stock. Similarly a GMAC preferred is selling for $6.25.

So if present investors are demanding 11-25% returns at the current level of risk why is the government settling for 5%?

Too much of this bailout looks like a way to push the real crash until after the election, and perhaps until all those in the current administration have secured there new revolving door jobs in the private sector starting in January.