With the government's stress test requiring ten of the nation's largest banks to raise new equity, several banks may ask the federal government to convert existing preferred shares into common stock. Such a conversion would effectively increase a bank's total equity, fulfilling the requirement of the stress tests.
But such a conversion would shift new risks to the government — preferred shares are less risky than common shares because they grant holders higher economic priorities, especially in bankruptcy proceedings. At the same time, common shares have more upside potential if the stock price increases.
The federal government was granted the preferred shares in return for providing financial rescue funds.
But the prickly question remains for the Treasury Department: What would be the conversion rate for shifting preferred shares to common stock?
Too low of a conversion rate could be a windfall to bank stockholders, but too high of a rate could result in massive dilution of shareholders with the government owning most of the bank's stock.
Treasury Secretary Timothy Giethner, while meeting with reporters following the release of the stress tests on Thursday, gave few clues. When asked about the conversion rate, his answer was essentially: Trust Me.
"If we had a request for a conversion, we would evaluate it very carefully. We are going to be very attentive to what's the best outcome for the taxpayers," he said. "We'll make a sensible judgment from the perspective of what is the right economics for taxpayers and what is the right overall benefit for the system."
In setting the conversion rate, Geithner said he keep in mind the overall goal of helping the financial system recover.
"I have two basic obligations," he continued. "I have a fiduciary obligation as an investor in these institutions. But I'm only an investor because of a broader obligation to make sure this financial system is stable, repairing, recovering, and doing what it needs for the economy as a whole. And these two broad objectives have to shape everything we do."
