Preferred, common: same banana

Technically, they’re not. But the latest in the government’s long list of hopeful plans make it seem like the two are completely different sources of capital.

The report from the NYTimes about the possible planned conversion of government’s preferred to common doesn’t provide much logic. The only ones in my mind are: the banks would be rid of the responsibility of paying the higher dividends and, worse, government gains bigger control of the banks.  But if the issue here is providing more capital, the conversion of preferred won’t do much.

Paul Krugman posted in his blog his views:

Now, preferred shares are sort of like a junior loan: the preferred shareholders are second in line for losses, but ahead of the rest of the bank’s creditors. So from the point of view of the creditors, capital includes preferred shares as well as common equity. Or to put it a bit more generally, from a creditor’s point of view capital is everything that has a more junior claim than you do.

But in that case, converting preferred into common does nothing: it’s just a swap among the junior stuff, with no impact further up the line. It’s certainly not a fresh infusion of capital in any meaningful sense.

And his analogy goes:

Here’s how I think about it: you started a business with a bunch of borrowed money, but of course had to put some of your own money in. Now, actually some of the money you put in was borrowed from your mother, but the original lenders don’t care about that, since they have prior claim.

Eventually you run into some business difficulties, and your creditworthiness is in doubt. What you need is evidence of ability to repay the money you already owe.

So does it help if your mother converts her loan into a share of the business? Not really, because she won’t get repaid anyway unless all your other creditors get paid first.

Some points made by James Kwak of Baseline Scenario:

By converting preferred into common, you haven’t changed the chances of the bank going bankrupt, because its assets haven’t changed, and its liabilities haven’t changed.

If you accept the idea that converting preferred into common creates new capital, then you are implying that those preferred shares weren’t capital in the first place.

More and more, it’s starting to look like the government is trying to dig deeper into a piece of land with the hopes it would find its way back up.

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2 responses to “Preferred, common: same banana

  1. If the firm is going into instantaneous bankruptcy right now, then yes. But the firm is going to be around at least two months: if you can’t make both this month’s payment to your mother and next month’s payment to your other creditors, doesn’t it help your other creditors if you stop paying your mother?

    • Hey Dan,

      If it helps at all, it’s only because there are no more preferred dividends to be paid. But the amount the banks save compared to the capital they would need in order to repay creditors or to absorb losses are highly likely to be inadequate.

      Plus, it is already a capital received in the past and the conversion that might happen is nothing but a “relabeling” of equity. The goal is to have significant additional capital, not merely to meet ratio requirements.

      Wouldn’t you agree?

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