Bankruptcy

: Credit Slips

Preferred Stock=Subordinated Debt

By Adam Levitin (index)

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 for common stock, 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, if he doesn't have redemption restrictions in the deal?)

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 type of capital, depending on the nature of the capital. 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, and if it were done as subordinated debt, it would be Tier 2 capital (not as good).

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. Preferred stock is cumulative if dividends that are not paid in a particular year roll over and add on to the dividends owed the next year. It is perpetual if it does not have a maturity and is not redeemable at the sole option of the holder.

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 (a Class B minority interest) counts as restricted Tier 1 capital. 12 C.F.R. Pt. 225, App. A. For a national bank, however, noncumulative perpetual preferred stock is counts as Tier 1 capital. 12 C.F.R. Part 3, App. A, Sec. 2. 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.

Full post as published by Credit Slips on October 14, 2008 (boomark / email).