Regulators pledge to shore up financial system

Federal officials told banks Monday that infusions of government bailout money would come with new strings attached -- specifically, the potential that taxpayer dollars could be converted into voting shares that would give the government more influence over how their institutions were run.

The move, announced by the Treasury Department and other regulators, would allow the government to provide more capital to struggling banks while giving the banks more flexibility in how the money is repaid.

Previous capital injections by the Treasury have involved purchases of preferred stock in the banks with a requirement that they pay dividends of 5% or 8% a year back to the government.


In the future, the banks would still sell preferred shares but would have the option of turning this nonvoting stock into common stock, so they would no longer have to pay the hefty preferred-stock dividends.

The banks also could ask to convert funds from previous government capital injections to common stock.

The plan includes trade-offs. By not paying dividends, banks will be able to preserve their capital. But the conversion to common stock, which has voting rights, would water down the holdings of their existing investors.

Without nationalizing banks outright, the conversion to common stock could make the government the controlling shareholder in some financial institutions, such as Citigroup Inc., which reportedly was in talks with the Treasury to convert a large portion of the government’s $45-billion equity stake into common stock.

The guidelines came in a public statement from the Obama administration and banking regulators that tried to ease fears about the potential for nationalizing major banks -- fears that caused banking stocks to crater last week.

The statement helped reverse huge declines in two battered financial sector stocks. Bank of America Corp., which dropped 32% last week, rose 3.2% on Monday to $3.91. And Citigroup, whose stock fell 44% last week, gained 9.7% to $2.14, benefiting from reports that the government could wind up with as much as 40% of the bank’s common stock -- but not wipe out existing shareholders entirely by nationalizing the bank.

But the Dow continued its slide Monday as last week’s pullback moved beyond the financial sector.

The statement issued by the Treasury Department, the Federal Reserve and the U.S. government’s three banking regulatory agencies said the government’s new financial stability plan contains “the strong presumption . . . that banks should remain in private hands.”

“The government will ensure that banks have the capital and liquidity they need to provide the credit necessary to restore economic growth,” the three-paragraph statement said. “Moreover, we reiterate our determination to preserve the viability of systemically important financial institutions so that they are able to meet their commitments.”

The statement said that future capital injections into banks would be in the form of preferred shares that would automatically convert to common stock at some later point.

Those mandatory convertible preferred shares would be converted into common stock only “to keep banks in a well-capitalized position” and the injections could be paid back to the government before the conversion takes place, the statement said.

Preferred shares are viewed as debt and converting them would help improve a financial institution’s balance sheet -- but at the cost of the government having substantial amounts of voting stock.

Financial institutions that received earlier capital injections under the Bush administration’s Troubled Asset Relief Program would also be eligible to exchange their preferred shares for common stock. The decision would be made by the institution in conjunction with the agency that regulates it -- the Office of Thrift Supervision, the Office of the Comptroller of the Currency or the Federal Deposit Insurance Corp.

The statement also said the Treasury Department’s “stress tests” on major banks would begin Wednesday. The tests will evaluate the capital needs of banks with more than $100 billion in assets over two years -- a longer period than the six-month or one-year time frames that regulators currently use -- and under different economic scenarios.

The government will give banks that need more capital the chance to first try to raise it themselves in the private sector. If they can’t raise the funds, federal officials would buy the convertible preferred shares to provide a “temporary capital buffer” as “a cushion against larger-than-expected future losses” if the recession worsens, the statement said.

“I think it removes a lot of uncertainty,” said Scott Talbott, senior vice president of government affairs for the Financial Services Roundtable, which represents large financial institutions. “It lays out with a large degree of certainty [conditions] for providing additional equity to banks should economic conditions require it.”

Citigroup probably sought the conversion to common shares to improve its capital in advance of the stress test, said Nancy Bush, an analyst at NAB Research in Annandale, N.J.

The switch to common shares boosts a capital measurement known as tangible common equity, which is the most stringent measure of capital, she said. Rating agencies and investors lately have focused on that equity to determine which banks have the financial wherewithal to ride out the recession, Bush said.

Bank stocks spurted higher in the morning as “short sellers” reversed their positions after the Citigroup news and the regulators’ statement. But the gains faded later because of doubt about the Obama administration’s strategy for overcoming the banking crisis.

“The government lacks credibility at this point on the issue of the banks. It’s that simple,” Bush said. “This is simply the market’s skepticism about Mr. Obama’s ability to fix it this time.”

The regulators’ statement also spooked investors.

“Every time the government opens its mouth these stocks go down,” Bush said. “Investors find it scary, frankly, when regulators come out and make these joint statements. It’s a flashback to last September” when Lehman Bros. Holdings Inc. went bankrupt.

The market sell-off was driven by investor alarm at the administration’s ungainly steps thus far at laying out a vision for rescuing the banks, said Jason DeSena Trennert, chief investment strategist at investment research firm Strategas Research Partners in New York.

“Investors want policymakers to adopt the Hippocratic oath, which is first do no harm,” Trennert said. “They’re worried that in the frenzy to fix the problem they’re going to do more harm than good.”

Investors also are worried about the higher taxes on capital gains and dividends that probably would accompany Obama’s planned deficit reduction, Trennert said.

Battered insurer American International Group also suggested Monday that it would be open to converting the preferred stock it sold to the Treasury into common stock.

“We continue to work with the U.S. government to evaluate potential new alternatives for addressing AIG’s financial challenges,” the New York company said in a statement.

The comment followed news reports that AIG was in talks with the government about the stock conversion or other support and that it would report a $60-billion loss. AIG said it would disclose details “in the near future” when it reports its fourth-quarter results.

AIG’s problems stem mainly from insuring mortgage-backed securities and other risky debt against default. As part of its $150 billion in government support, AIG received $40 billion in TARP funds last November in return for preferred stock. That stock requires AIG to pay the Treasury a 10% annual dividend, or $4 billion a year -- a payment that it would not have to make if the stock was converted into common stock.

A Bank of America spokesman said the company was not discussing conversions of preferred stock to common stock with the government. The Charlotte, N.C., bank also sees no need for more capital than the $45 billion the Treasury already has invested, spokesman Robert Stickler said.

Stickler said Bank of America remained fundamentally profitable despite reporting a large fourth-quarter loss and was well capitalized with an “extremely high level of liquidity.” He declined, however, to say whether the bank had enough capital to pass the government’s planned stress test.

“We do not know what the stress test parameters will be,” he said.

With few details of the stress test and of the conversion program available until Wednesday, it was unknown whether the program would be applied widely or what its effect might be, said Bert Ely, an Alexandria, Va., banking consultant.

Ely said it was likely that only weaker banks would apply for conversions. Not having to pay dividends to the government could be a plus for those banks, outweighing the fact that their existing shareholders would see their investments diluted by the government taking a stake, Ely said.