Monday, November 24, 2008

Leverage by the numbers, Part 3

(Rolfe Winkler in Option ARMageddon) Why am I excluding preferred capital? A great question from reader Mark. GE and GS are both on my leverage chart, and not only an I excluding the preferred capital they raised from Buffett, I’m excluding the TARP capital injections as well. Those represented increases in “bank capital,” and yet I’m not including them in my calculation of equity in the chart. Here’s why, from the Treasury’s press release announcing TARP:

Under the [TARP] program, Treasury will purchase up to $250 billion of senior preferred shares on standardized terms as described in the program’s term sheet…

The senior preferred shares will qualify as Tier 1 capital and will rank senior to common stock and pari passu…

“Pari Passu” means “of equal step” in Latin. So the preferred shares purchased by Treasury with the TARP money, and other preferred issuances to Buffett for example, rank “senior” to all common equity and anything else equivalent to it in the company’s capital structure.

What does that mean in English? That common shareholders are still in-line to absorb the first losses. If assets fall in value, common equity is the first thing to be marked down. And it will get marked to zero before the preferred starts to lose dollar 1.

That’s why banks stocks kept falling despite the TARP bailout, especially after Paulson said the government wouldn’t be buying troubled assets. When he said that, it became clear common shareholders would be the first to lose.

But not anymore! With the Citigroup bailout today, the government is actually agreeing to absorb hundreds of billions of losses BEFORE common shareholders lose anything. That’s why financial stocks are up huge, because Paulson reversed himself, saying the government WILL absorb losses.

Citigroup’s stock price confirms what the rest of us know to be true: this latest bailout (and all similar ones to follow) is simply a transfer of capital directly from taxpayers to Citigroup shareholders, to the tune of hundreds of billions of dollars.

By the way, here is a good piece from the FT’s blog on why it’s important to exclude preferred shares when calculating leverage. Quoting analysts from FBR:

The straight-forward “tangible common equity to tangible asset” ratio is the only true measure of leverage and the only capital ratio that should matter to common shareholders. Tangible common equity is in the first loss position in the capital structure (allowance for loan losses aside). Any losses reduce tangible book value, which is a primary driver of a company’s stock price performance. If the reduction to tangible book value is significant and the company’s stock price falls, the company loses financial flexibility, which increases the possibility of failure, regardless of preferred equity levels.

According to FBR’s math, the government needs to heave AT LEAST $1 trillion more of tangible common equity at banks in order to rescue the U.S. financial system.

No comments: