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A Second Try at Calming Bank Investors
Government Wants New Infusions to Be Regarded as Capital

By Binyamin Appelbaum
Washington Post Staff Writer
Wednesday, February 25, 2009

The revised financial aid plan for troubled banks that the Obama administration is launching this week is the government's second attempt to convince investors that it is giving banks the money they need to cover mounting losses and survive the recession.

The government has insisted that its investments should be counted as capital, the reserve that banks must maintain against losses. The Bush administration went so far last year as to rewrite the regulatory definition of capital to include the federal aid, which comes in the form of preferred shares.

So far, investors have not been swayed. To them, the government aid doesn't look like reliable capital. It looks a lot like a loan that the government wants back.

"When you're not sure about a bank's losses, you're going to pay a lot of attention to the cushion that protects you against those losses. And in all the markets that matter, they don't really have a lot of regard for official capital reserves," said Richard Herring, a finance professor at the University of Pennsylvania's Wharton School.

To address the skepticism, the Obama administration is now changing the rules to allow banks to convert the government's investment into the kind of capital investors take seriously: common shares.

But officials don't want that conversion to actually happen, because then the government would end up owning banks.

These officials hope that investors will accept the banks' access to capital as equal to actual capital, and therefore the banks will never need to make the switch.

The success of the government's strategy can be seen beginning today, as investors judge the gambit and decide whether to put their own money in bank shares.

Officials believe the gamble is worthwhile to avoid taking ownership of banks.

"I don't see any reason to destroy the franchise value or to create the huge legal uncertainties of trying to formally nationalize a bank when it just isn't necessary," Federal Reserve Chairman Ben S. Bernanke said yesterday in testimony before Congress. "I think what we can do is make sure they have enough capital to fulfill their function, and at the same time we exert adequate control to make sure that they are doing what's necessary to become healthy and viable in the longer term."

Officials plan today to describe a systematic approach that will use "stress tests" to measure how much more capital many of the largest banks will need. The banks then will be instructed to raise the money from private sources or accept it from the government.

"For these companies to have access to capital in the form of common equity when they need it, that is a confidence-building measure," a senior administration official said. "If they can't reach that point privately, we are prepared to stand behind them to make sure they have access."

The timing of the announcement remained uncertain late yesterday, and administration officials were still working to finalize details. But in recent days officials have offered a clear sketch of the administration's strategy.

Banking regulators will require 19 large banks to perform detailed projections of the losses they would incur if the nation's economic problems, including unemployment and declining home prices, deepen significantly. The tests will project losses over the next two years, Bernanke said yesterday.

Bernanke said the government would calibrate the tests using "both a consensus forecast -- where we think the economy is likely to be based on private-sector forecasts -- and an alternative which is worse." He said the goal was a "tough evaluation" that would not allow banks to conceal problems.

The government hopes to complete the tests in the next several weeks, officials said.

Companies that need government money will be required to issue preferred shares that pay the government a regular dividend, basically the same terms on which the government has invested almost $200 billion in more than 400 banks since November. The key difference is that the preferred shares can be replaced with common shares.

The change is critical because of the accounting rules that govern what kinds of money banks can count as capital. The basic rule is that capital is money a bank never needs to repay. The most basic form of capital is money raised by selling common shares.

Many investors do not regard preferred shares as capital because the dividend on those shares rises sharply after five years, encouraging repayment.

The Treasury Department pushed banking regulators in November to declare that preferred shares counted as capital, but investors were not convinced.

Some leading financial analysts and economists have doubts that the plan will work. They said that banks must be recapitalized on a massive scale, if necessary through a process in which the government would seize the most troubled companies, strip them of toxic assets and then return them to private hands.

"I think the end game of this has to involve receivership for most of the largest financial institutions. Receivership and then reprivatizing them," said Kenneth Rogoff, a Harvard economics professor. "You can't guarantee that it's going to work. But looking at the history of financial crises, there are very few examples of another successful exit strategy. And every month we wait to act adds to the depth and duration of the recession."

Staff writers David Cho and Neil Irwin contributed to this report.

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