Why have the bank stocks soared over the past few days? Because Treasury Secretary Tim Geithner found a way to quietly shovel buckets of taxpayer money to them without many taxpayers noticing.
When Geithner’s latest plan (CAP) was announced, we noted that taxpayers were taking it on the chin because of the conversion price of the convertible preferred stock the government will be buying. In many cases, this conversion price was well above where the bank stocks were trading, resulting in a gift from you to the bank.
But as James Kwak notes at The Baseline Scenario, it’s actually much worse than that. The “mandatorily convertible preferred stock” that the banks will issue, in fact, only converts to common stock at the bank’s option, not the government’s option (or not, as we expected, automatically, based on a capital ratio). Which means that the banks don’t have to convert the preferred to common unless they want to.
Why is this important? Because taxpayers are giving the banks a free put option. And that put option is actually worth a lot of money.
Under the new Capital Assistance Program (CAP), the government will invest in banks by buying preferred shares with a 9% dividend. This is like the old Capital Purchase Program (used last fall for the first round of recapitalizations), but with one huge twist. Now the bank, AT ITS OPTION, can choose to convert the preferred shares into common, at 90% of the average closing share price during the 20 days ending on February 9 (the day before the new Financial Stability Plan was “announced”).
An example would probably help here. Let’s say that Bank of America (BAC) needs another $25 billion in capital. The government will give BAC $25 billion in cash, which BAC has to pay back in 7 years (that’s the mandatory conversion date). In the meantime, BAC has to pay 9% interest, or $2.25 billion, per year. But, at any time, BAC can convert any amount of that to common shares, at $5.49 per share. (The average closing price over the 20 days was $6.10.) If it converted $5 billion into common, the government would get about 910 million (5 billion divided by 5.49) common shares, but now BAC only owes the government $20 billion and is paying 9% interest on only $20 billion.
In short, BAC has just sold the government 910 million shares for $5.49 each.
This is called a put option. At any time, BAC can sell (“put”) shares to the government for $5.49, but it never has to. (The convertible shares the Silicon Valley VCs get are like call options; at any time, they can buy common shares by trading in preferred shares, but they never have to.) Having an option is always good.
What will BAC do with this option? If its stock price is above $5.49, it can either do nothing, or it can issue new common shares and sell them to private investors, say at $8. Then it can use that $8 to buy back preferred shares from the government, or just hold onto it. If its stock price falls below $5.49, things get interesting. Then BAC can buy up its shares on the market for, say, $3, and then immediately sell them to the government for $5.49. It won’t get $5.49 in new cash, but it will reduce its debt to the government – because preferred shares that have to be bought back and pay interest are basically debt – by $5.49, which is almost as good.
(This would have the side effect of supporting BAC’s stock price, because it means there is a buyer (BAC) who is theoretically always willing to pay $5.48 for the stock. Ricardo Caballero must be smiling).
And how much is that put option worth? A lot:
What you’ve just done is stick the government with the downside risk – we could get paid back in worthless stock – while the bank shareholders get all the upside potential. You’ve done this by giving the bank, for free, an option that has value. Back of the envelope, Peter thinks this option is worth about 65 cents per dollar of money invested. (It’s worth so much because bank stocks are so volatile these days.) Put another way, for every $10 billion of capital we invest this way, we are giving away another $6.5 billion. I think it’s probably a little less, because the option is not as flexible as the holder would like it to be, but you get the point.
As I’ve said many times before, if you think the banks need money, and you want to give it to them (instead of, say, nationalizing them), just give it to them already. Don’t come up with these ridiculously fancy schemes to hide it. Yesterday Krugman gave Simon and me credit for writing this sentence:
This is another sign of the serious brainpower that has been expended on finding ways to avoid or minimise government ownership of banks, and to avoid the slightest possibility of offending shareholders – shareholders whose shares have positive value primarily because of the expectation of a further government bail-out.
But to tell you the truth, at the time we wrote that I didn’t realise just how much brainpower went into this one.