Treasury begins stress testing banks (converting government stakes to common shares)

Market Watch ^ | 022509 | Ronald D Orol

[Fred]

The Treasury Department on Wednesday began to apply a series of new stress tests for the nation's 19 largest banks as part of a new capital injection program that could lead to the nationalization of several financial institutions.

According to the "stress test" approach, government regulators are looking at each financial institution's balance sheets and capital needs over the next two years and evaluating how much capital the company will need over that period.

Based on that analysis, the government would press financial institutions to convert their taxpayer-funded preferred shares into common shares when losses that were forecast by the stress test actually occur. Federal Reserve Chairman Ben Bernanke discussed the stress test plan, known as the Capital Assistance Program while testifying before the House Financial Services Committee. More details are expected this afternoon.

As part of the plan, a bank could also receive new government-funded preferred shares that are converted to common shares if it turns out projected losses materialize. Like the stakes banks have already received from the Treasury, these new shares are issued in exchange for taxpayer funds.

Investors in common shares are concerned about the plan for two reasons, at least.

Preferred shares are higher in the capital structure of a company, and in the event that a firm goes bankrupt and is liquidated, preferred shareholders could be in line to collect something, while common holders would get nothing.

Shareholders are also concerned about the conversion of preferred shares into common because such a move would make current shares worth less through dilution. In other words, the more shares of common stock outstanding, the less valuable each share is.

However, Bernanke argues that the new

[livius]

Common shares are voting shares.

[GovernmentShrinker]

Not necessarily, but in this case they will be.

I’d love to know the details of this “stress testing”. I can assure you that every rated mortgage-backed derivative security that has been issued in the past 20 years was subjected to “stress testing” by the rating agency and the underwriting institution, and passed with flying colors. Stress testing involves a “worst case scenario” model, with “worst case” usually being defined by some clueless 20-something analyst. I’ve seen “worst case scenarios” that involved a 10 percent drop in top line revenues. The only clue the 20-something analysts actually have is that if they produce a “worst case scenario” model that doesn’t show the issue or credit still performing marvelously, they’ll soon be unemployed.

[ding_dong_daddy_from_dumas]

Paulson sold the TARP based on the promise that the bailees would repay most of the TARP money. Now AIG wants to redo the TARP agreement (again), this time to convert preferred shares to common shares (in Bernanke’s current plan, “under certain conditions”). It seems to me, that makes it less likely that AIG will ultimately have to repay. AIG, it should be noted, has a lot of “toxic assets” in Asia, and I wonder if AIG will be sucking even more money from us to China:

- Via interest on the money “our” government is borrowing

- Via shadowy Asian connections. Remember how banks getting TARP money refused to disclose where the money went?

[razorback-bert]

He said that as long as there were some private shareholders in the biggest banks, any government investments in the banks would not constitute nationalization.

Okay, just semi nationaliztion.

I am so reassured.

[livius]

The only clue the 20-something analysts actually have is that if they produce a “worst case scenario” model that doesn’t show the issue or credit still performing marvelously, they’ll soon be unemployed.

Which brings me to another point...I wonder if many people realize how many financial decisions are made on the basis of the pronouncements of 20-somethings who (a) don't have a lot of experience or knowledge and (b) wouldn't be capable of defending their decisions if by some fluke, they weren't what everybody wanted to hear.

[GovernmentShrinker]

Basic assumptions of the stress testing are out today: 10.3% unemployment, further 25% drop in housing prices, 3.3% contraction of GDP. http://online.wsj.com/article/SB123557705225772665.html If you count “discouraged workers” (no longer looking for work), unemployment is already well over 10%. And a good chunk of those may be forced to start looking again, as things get worse.