Reply #19: Geithner's New Bank Fix Is Bogus, Too

[Demeter]

http://www.businessinsider.com/henry-blodget-geithners-new-bank-capital-plan-is-bogus-too-2009-5


Tim Geithner has a clever new way to "recapitalize" banks that fail the stress test: Convert the taxpayer's preferred stock to common stock.

From Geithner's perspective, this technique has several advantages:

* The banks will suddenly seem healthy, because their assets-to-common equity ratios will rise.
* Geithner doesn't have to ask Congress for more baillout money yet.
* Taxpayers won't understand that they're giving up a nice dividend and a safer security just to make the banks look better.
* If Geithner is right that what's wrong with the banks is just a temporary liquidity problem, the taxpayer should do well when the stocks rise. (We don't think he's right.)

Unfortunately, the plan also has two major flaws: First, it's smoke and mirrors. Second, the taxpayers will be even more exposed to losses than they are now.

Why?

Because the banks will still have the same amount of crap assets on their balance sheets, and they'll have no more capital available to absorb these losses when they hit. The only thing that will change is that the taxpayer will now get hit first as these losses flow through, instead of getting hit second, as is the case now. The banks' bondholders, meanwhile, will still be protected to the tune of 100 cents on the dollar (by administration policy). If the common equity is wiped out by the losses, therefore, the government will have to dig into the taxpayer's pockets to cover any shortfall. (See Paul Kasriel's detailed explanation below).

In other words, Geithner has hatched yet another plan to avoid dealing with the bank problem once and for all.

How would he do that?

As we've argued, we think the best way would have been to seize the banks and restructure them. Since Geithner has opted against the route, however, the next best way would be to convert unsecured bank debt to equity, not just the taxpayers' preferred stock (the taxpayers' preferred stock should have been senior to all the bondholders, but that's spilt milk at this point).

Converting actual debt to equity would give the banks a much bigger cushion with which to absorb losses. It would split the bank ownership up among current common shareholders, taxpayers, and current debtholders, which would help Geithner avoid having to take full control. It would also, finally, stop exposing the taxpayer to further losses.

The idea that bondholders should share the bank pain is finally gaining some momentum. Let's hope that continues in the coming weeks.

EXAMPLE CALCULATIONS AT LINK