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NEW YORK The U.S. government may want to consider converting the preferred shares it has bought in troubled banks into common stock to boost capital levels at no initial cost to Uncle Sam.
Britain did the same thing with the Royal Bank of Scotland Plc (RBS.L), which should reduce the bank's annual preferred dividend costs.
U.S. banks could also benefit substantially. For example, the government now owns more than $45 billion of preferred shares in Bank of America Corp (BAC.N), the largest U.S. bank. The bank is paying more than $2.8 billion in dividends a year on those preferred shares.
Turning the preferreds into common would instantly save the bank money it sorely needs, and would bolster a key measure of the bank's capital strength by more than 70 percent instantly. Other banks that have received money from the Treasury, including Citigroup Inc, (C.N) could also benefit.
"If it gives common shareholders the chance to get some money back and stabilizes financial companies, it's worth considering. It seems like a no-brainer," said Bo Brownstein, chief executive of Big Five Asset Management in Denver.
The move would not completely fix the banking system's capital problems, but it would go a long way toward helping.
There is at least one obstacle to such a conversion plan: It would be tantamount to nationalizing the banks. Even now, with a new, left-leaning administration and the financial crisis worsening by the day, the United States seems reluctant to nationalize major banks. Obama administration officials have not discussed nationalization.
"It would reflect a real shift in national economic philosophy. It's thought to be a great interference with the free market," said Roy Smith, a finance professor at New York University's Stern School of Business.
New York Federal Reserve Bank President Tim Geithner, Obama's nominee for U.S. treasury secretary, discussed his plans for saving the bank sector in his confirmation hearing
on Wednesday, but stopped short of mentioning nationalization.
Last Friday, Federal Deposit Insurance Corp Chairman Sheila Bair said the government is looking at setting up a taxpayer-funded bank to buy troubled assets from financial institutions. Bair said last week that she would be "very surprised" if any major U.S. banks were nationalized.
The government could convert its preferred shares into common stock without nationalizing banks. For example, taxpayers could receive a special class of common shares with no voting rights.
Or the government could receive change its preferred shares into convertible preferred shares that pay no dividend and have no voting rights. If done properly, the securities might be similar enough to common equity to soothe investors and rating agencies.
According to recent news reports, the government is looking into buying convertible preferreds from banks, which could serve a similar function.
Longer term, if politicians are less reluctant to seize control of large banks, the conversion idea may be a relatively cheap and fast way to do it.
DEJA VU ALL OVER AGAIN
The government's plan to set up a bank to buy bad assets may be deja vu for investors. It is essentially the same as the original plans for the U.S. Treasury's Troubled Asset Relief Program (TARP).
One problem with buying assets through TARP, or a new bank, is that many banks are recording assets on their books at values that are too high.
If the government bought the assets at those high prices, taxpayers would bear massive losses and the U.S. would essentially be handing a huge subsidy to the banks' equity investors.
"It's free money for shareholders. It would encourage banks to do just what they had done, and leave taxpayers holding the bill," said Daniel Alpert, managing director at Westwood Capital in New York.
But buying assets at too low a price would likely force banks to recognize major losses, which would weaken them further.
"The whole idea is a huge mistake," Alpert said.
With TARP, instead of buying assets, the government has been buying preferred shares and warrants to boost banks' capital. The Treasury has bought a total of about $300 billion in preferred shares from banks so far. Last week, the U.S. Senate voted to release another $350 billion in TARP funds.
If buying assets through a new bank does not work, converting TARP investments may. Consider Bank of America, which has sold $45 billion in preferred shares to TARP.
If the preferred were converted to common, the bank's total tangible common equity would instantly rise to $108.5 billion, giving it a tangible common equity ratio of 4.5 percent, 73 percent above the current ratio of 2.6 percent. Other banks could reap similar benefits.
The tangible common equity ratio measures how much of a common equity cushion the bank has to absorb losses, ignoring intangible assets that may not help the bank during difficult times.
Converting preferred shares to common would mean the government would give up dividend income and some protection if a bank went bankrupt. But that's a small price to pay for such a huge infusion of common equity, said a senior official at a major bank, who declined to be identified.
"In this environment, people want banks to hold more capital, not less. It's not coming from the private sector, so the government is the only place you can go. Converting preferreds helps that problem quickly," the executive said.
(Editing by Jeffrey Benkoe)