The New York Times reported yesterday that the government is likely to begin converting the government’s existing loans to the nation’s 19 biggest banks into common stock. Paul Krugman is not a fan of this strategy, and he makes that clear by analogizing it to yo' momma (you think I'm kidding. I don't kid.). Felix Salmon is more positive. Reports, however, have suggested that the Treasury Department is embracing as a way of stretching the remaining TARP dollars rather than as a policy to better the health of the banking system. That, as some have noted, doesn't make a whole ton of sense. But the theory, as I understand it, is a little bit different. This doesn't increase the bank's access to public dollars. Rather, it increases the bank's access to private dollars. Here's how it works: The government has used a lot of its TARP funds taking out preferred shares in the banks. The banks, in theory, will pay that money back once they are healthier. But healthier might take awhile. Healthier might require more funding. Meanwhile, the government's TARP funds are running low and it doesn't want to go back to Congress for a fresh infusion. So the question becomes how can the administration give banks access to more funds without requiring a congressional vote? This plan seems to be their answer. Imagine you loaned your buddy's business $10,000. He now owes you $10,000. But your buddy needs more loans and you don't have more money. So you change the terms of the deal. That $10,000 ceases to be a loan. Instead, you now own $10,000 worth of your buddy's business. He doesn't have to pay you back, so his balance sheet looks better. This makes it easier for him to get another loan. That creditor won't have to wonder whether he'll still get paid back after your friend first pays you back. This entails some new risk for the taxpayer. The preferred shares acted much like a loan. So long as the bank was solvent, we were pretty sure to be repaid. Equity isn't like that. If the bank limps along, and we want to cash out our equity at some point, we may well lose money on the deal. The point of dispute between folks like Krugman and folks like Salmon is whether you think the preferred shares that the government previously held were more like loans or more like equity. If the market was indeed treating them as equity, then this won't increase capitalization much. If it was treating them as the equivalent of bonds, as Salmon suggests, then it well might. The answer, in theory, will come clear soon enough. Meanwhile, when the story of all this is written, the amount of effort the administration expended finding clever ways to avoid Congress will play a starring role.
