Equity Preferred to Debt

I rather like this bit of CNBC interview with Ken Lewis, helpfully transcribed by Calculated Risk:

Q: What about capital adequacy. Are you expecting to raise new capital?

Lewis: We are not expecting to need more capital. The issue of course - which was brought up today which is hurting all bank stocks - will some be required convert some of their preferred to common. We don't think we have an issue there. But that is now in the hands of the regulators, and we have not heard back from them at this point in time.

Q: What should we look for as far as the most important things to come out of the stress tests?

Lewis: I think it will be what requirements are there on what banks in terms of conversion of TARP preferred into TARP equity.

Q: You said you want to pay back the TARP money in 2009. Is that still on the table? Are you expecting to pay back that TARP that soon?

Lewis: Well, we would like to, and we would prefer to. But again that is now in the hands of the regulators and we will be in consultation with them as to what the best avenue will be in that regard.

Lewis makes it sound (accurately, I think) that there is little agency for banks in these decisions, at least for the shakier of the bunch. What will be will be. The government will figure out how big a capital hole it will need to plug and plug it, and Lewis will continue to look forward to paying back TARP -- as soon as Treasury says it's ok. Fear government control in a nationalization scenario if you want, but it's pretty clear that for the banks in dire straits, Treasury already has a heavy hand on the wheel. And increasingly I'm inclined to see the Treasury as herding banks into different categories -- those it can wean off support, and those who will be needing the support freed up by the weaning of the other banks. My question, of course, is where Citi goes. It needs a third category -- ?!?1!

In some ways, though, the conversion could be freeing to banks. Mike at No Empty Wallets quotes Linus Wilson on the incentive effects of changing preferred shares to common:

Even if no new money goes into banks, common stock creates different incentives than preferred. Managers, if they are doing their job, maximize the value of common stock (not preferred stock). Limited liability means that a distressed bank will have perverse incentives until it has enough common stock to absorb those losses. With too little common equity, banks will pass up good loans because too many of the gains are realized by preferred stockholders and debt holders. Managers running banks with too little common equity will be tempted to make speculative loans and shift those losses onto senior creditors (preferred stockholders and bondholders).

That's an interesting argument. The tricky bit is that it's not clear to me that undercapitalized banks are making risky loans, even though proponents of nationalization have maintained that that's the natural incentive for managers of insolvent institutions. But this also gets at one of the key questions concerning the banking crisis -- why aren't banks lending? Some of them are, of course, but why aren't they lending more? Is the problem a decline in demand for credit or is it directly related to balance sheet issues? The import of the point is this -- as demand for credit grows with recovery, will the sick banking sector constrain growth, or will healthier banks and other credit markets meet the demand?

We'll see.