By Binyamin Appelbaum and David Cho
Washington Post Staff Writers
Tuesday, February 24, 2009
The Obama administration yesterday revamped the terms of its emergency aid to troubled financial firms, setting a course that could culminate with the government nationalizing some of the country's largest banks by taking a controlling ownership stake.
Administration officials said the change, which allows banks to repay the government with common stock rather than cash, is intended to give banks more capital to withstand a continued deterioration of the economy, and not to nationalize the banking system.
But in seeking to bolster investor confidence in troubled companies such as Citigroup, the government said it is willing to acquire large chunks of their shares. .
The move is a significant gamble. The magnitude of the effort could underscore the severity of the crisis, further alarming investors. The government could also forego billions of dollars in dividend payments.
Some investors welcomed the announcement. Even as the Dow Jones industrial average fell 251 points to its lowest close since 1997, shares of Citigroup climbed 10 percent. Shares of another troubled firm, Bank of America, rose about 3 percent.
The change paves a road toward nationalization for the most troubled large banks. The government this week will begin a series of "stress tests" on 20 of the largest banks with $100 billion in assets to determine how much more capital these firms need to withstand an extreme recession.
Companies deemed to need more money will be required to raise it from private sources, or else accept additional government investments. If those investments are converted into common shares, even a relatively modest infusion of taxpayer money could give the government majority control of many banks because their stock prices have plummeted in recent months. The total value of Citigroup's outstanding shares, for instance, is less than $12 billion.
Administration officials said the goal of the revised program is to give banks a short-term boost that avoids the need for a more dramatic federal intervention.
What Treasury Secretary Timothy F. Geithner and his team want to avoid is an explicit takeover that would put the government in charge of running banks. But some senior officials have said that, as a last resort, they would consider taking temporary control of large banks. The government also could take a majority ownership stake in a company without attempting to manage its daily operations.
A wide range of prominent economists and public figures have called for the government to take this step. But a backlash is building against government ownership.
Sen. Charles E. Grassley (Iowa), ranking Republican on the Senate Finance Committee, sent Geithner a letter yesterday demanding details of the administration's plans. "Common stock is riskier than preferred stock. The American taxpayers are already shouldering a lot of risk these days," Grassley said in a statement. "This move could expose taxpayers to even more risk."
Even within the government, some senior officials say they are worried that Geithner's approach has left investors unsettled because of ambiguity over the administration's intentions.
The government has invested almost $200 billion in more than 400 banks under a program created by former Treasury Secretary Henry M. Paulson Jr. In exchange, the government received shares of preferred stock that paid an annual interest rate of 5 percent for five years.
The changes announced yesterday create a two-step process, officials said. Companies can replace the government's preferred shares with a new kind of preferred shares that will differ in at least one critical respect -- they can be converted into shares of the company's common stock. The company can request the conversion at any point during a specified period of several years, or else the shares will begin to gradually convert into common shares over time. If the company does not want to issue common shares to the government, it must buy back the government's preferred shares before the end of the period. Conversions will require the approval of banking regulators with final approval from the Treasury Department, a senior administration official said.
The change in terms could improve the health of banks without requiring the government to invest additional money.
Companies that convert the government's investment to common shares can reduce required dividend payments, allowing the largest banks to save billions of dollars. There is also an important accounting benefit that improves the value of the government's investment as a cushion against future losses.
Under accounting rules, banks are constrained in their ability to count the money raised by selling preferred shares under the narrowest definition of that capital cushion, called tangible common equity. Investors viewing banks with an increasingly jaundiced eye have increasingly favored that narrowest definition, and as a result, they have excluded the government's initial round of investments from their calculations of how much money banks hold in reserve. Issuing common shares would allow banks to improve their performance on that narrowest measure.
But if the government effort to revive the banks is unsuccessful, the change unveiled yesterday increases the risk that billions of dollars in taxpayer money could be lost. The Bush administration structured its investments to resemble loans, with regular dividends and some chance to recover money if a bank fails. Converting those investments into common shares reduces or eliminates the dividends and the protections, but it also allows taxpayers to benefit if companies return to profitability.
Scott Talbott, a spokesman for the Financial Services Roundtable, said the changes showed the government's support for the industry.
"This is a signal that the government believes the financial institutions are strong and provides them with the flexibility of terms should the economy worsen," Talbott said.
Citigroup pushed for the change in terms, according to people familiar with the matter. The company is walking a fine line between its need for explicit government support and its desire to remain independent.
The government already has invested $45 billion in Citigroup and promised to limit its losses on a portfolio of more than $300 billion of loans and other troubled assets. Senior Citigroup executives approached federal regulators to urge that the government convert parts of its investment to common shares, the sources said. The company hopes to reassure investors and attract new money.
David Dreman, chairman of Dreman Value Management, which as of the end of last year was among the top 70 stakeholders in Citigroup with more than 9 million shares, said he was comforted by the government's latest move yesterday. "It looks like the government is going to get them out of this. They're going to give them enough money so they don't go under," he said.
Brett Hammond, chief investment strategist at TIAA-CREF, another large Citigroup shareholder, said while a larger government stake would initially hurt existing shareholders, it would be better for them in the long run.
"I think you have to take the big view," he said. "It's better for the shareholders for government to take some action rather than no action. There's a much better chance that Citigroup will survive now and therefore live to pay dividends another day."
Staff writers Neil Irwin and Tomoeh Murakami Tse in New York contributed to this report.