The federal government owns preferred stock in many of the banks it has bailed out.  According to the NYT, it is thinking about converting this preferred stock to common stock.  The article also claims that this reduces the need for a further capital infusion and hence the need to go back to a feisty Congress for more money.

How could that be?  Isn’t the re-labeling of stocks going to leave banks with exactly the same amount of capital and not change anything?  This is just rearranging chairs on the Titanic.

The key sentence is the article is:

The administration said in January that it would alter its arrangement with Citigroup by converting up to $25 billion of preferred stock, which is like a loan, to common stock, which represents equity.

Preferred stock used to recapitalize banks does not come with voting rights but does come with a compulsory dividend.  It is 5% now and rises to 9% after five years.  In that sense, the preferred stock are more like debt that equity.  There is a risk that a bank defaults on this in the same way it could default to other debt holders.  Converting it to common stock implies the government gets voting rights but gives up the dividend.  This reduces the payments the bank has to make on a regular basis and hence makes  it more liquid. This appears to be the main idea.  It is good for the banks as their debt obligations are reduced.  It makes it more likely they survive.

What about taxpayers?  They are taking on more risk as their stake is more junior than before.  There are two countervailing effects.  First, maybe the probability of bankruptcy goes down as a result of this so the risk goes down.  Second, the initial decision to acquire preferred stock may have been politically expedient in which case it did not maximize shareholder/taxpayer value.  There is the perception of a big political cost of being seen to nationalize banks.  The initial plan reflected this political constraint.  This plan is a move to pay this cost to avoid the new political constraint, the cost of going to Congress.  So, maybe the Congress constraint is helping Obama to move to the economic optimum from the constrained political optimum as one political constraint cancels out the other.

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