Bank Capital: This Week’s Hot Topic?

Just a gentle reminder to you all that we’ll be hearing a great deal about bank capital once again this week. Well at least it makes a change from Chrysler. The auto and banking industries have become the ugly stepchildren of this recession: both mired deeply in the muck and both very expensive to fix. Or maybe they’re the poster children of Reagan era and how not to run a business?

Either way when the bank stress tests get released later this week, assuming the administration doesn’t cave in once again to pressure from the larger and weaker banks [you know who they are!] we will be focusing our attention back on the adequacy, or otherwise, of their capital. From any impartial perspective one or two of them are well below ‘adequate’, so as soon as we learn that they have failed the stress tests we should be treated to a barrage of opinions about how to correct their deficiency. Just as naturally, there will be howls of outrage from the banks in question, with each claiming that its position is just fine thank you, albeit it a little weak on the surface.

I am continually baffled at the ease with which folks like me seem not to understand the essential strengths of banks like Citibank and Bank of America, both of whom think that their assets are a lot less shaky than anyone else does. You’d think that after all their efforts to come clean and explain their balance sheets with clarity and honesty the market would understand by now that their apparent abundance of toxic assets is a mirage created by the market’s misunderstanding of those asset’s underlying value.

Setting aside my sarcasm: the problem I have is that the above comment seems to be exactly in line with where Tim Geithner’s thinking as been. He has said that he is with the banks in believing that their assets are worth more than they could currently fetch on the market. Consequently he has been inclined to take a more benign view of their capital adequacy than someone like me: I tend to be swayed by little things like what the bank’s balance sheets actually say rather rather than what the bankers would prefer them to say.

All of this is by way of warning: we are about to see whether the administration has the fortitude to deal with the banking question, or whether it still wants to punt the problem downfield and hope for the cavalry to arrive from somewhere else.

The early indications are not hopeful.

Geithner is still plugging his plan to ‘solve’ the lack of capital at Citi and B. of A. by converting some of the government’s preferred stock into equity. Recall that when the government handed over cash to the banks they gave us back an IOU in the form of preferred stock.

Now, the problem with Geithner’s plan is that preferred stock already counts as capital: it is a component of ‘Tier 1 capital’ as defined by international agreement. So swapping it for equity does nothing at that level. The only ‘improvement’ that such a swap would produce is to increase an even more arcane ratio called tangible common equity [‘TCE’] which used to be of lesser importance until the Treasury realized that it was cheaper to window dress that ratio through these preferred-for-equity swaps than it was actually to fix the banks properly.

Plus there’s a big downside for taxpayers in the Geithner plan – I can hear you all shouting ‘surely not!’. Preferred stock throws off a nice annual dividend. So the taxpayers get money back on their loan if it is accounted for as preferred stock. Not just that, but in the event of further losses and therefore hits to capital, equity gets run down before preferred. So preferred stock is safer than equity.

So let me get this straight:

Geithner’s plan is to swap our preferred for equity, which has absolutely no capital bolstering effect other than window dressing TCE, while it weakens the safety of the taxpayer loans and eliminates the dividend we were receiving.

I don’t want to appear negative. In fact I would love to support the administration. It’s just that this plan is stupid. It sucks. It is a sign of weakness. And it needs to be dumped quickly.

Hopefully by the end of this week we will learn that it was simply a ruse and that the administration was determined all along to face down the bankers and take the harsh measures necessary to deal once and for all with the weak banks.

I can hope can’t I?

What’s the alternative?

Can you say ‘zombie’?

Addendum:

The argument rages on through the weekend. Here’s how it gets convoluted: the two really weak big banks, Citi and B. of A. are contradicting themselves in their anxiety. On the one hand they are arguing they are sufficiently capitalized and therefore need no further government aid. And on the other they are trying desperately to raise capital. If their public position about their capital position is correct why do they bother going to market?

Ummm. I don’t know either.

It just seems odd to me. Well I suppose that one can never have enough capital. So raising some more is always a good thing.

Right?