Tim Geithner has a clever new way to "recapitalize" banks that fail the stress test: Convert the taxpayer's preferred stock to common stock.

From Geithner's perspective, this technique has several advantages:

The banks will suddenly seem healthy, because their assets-to-common equity ratios will rise.



Geithner doesn't have to ask Congress for more baillout money yet.

Taxpayers won't understand that they're giving up a nice dividend and a safer security just to make the banks look better.

If Geithner is right that what's wrong with the banks is just a temporary liquidity problem, the taxpayer should do well when the stocks rise. (We don't think he's right.)

Unfortunately, the plan also has two major flaws: First, it's smoke and mirrors. Second, the taxpayers will be even more exposed to losses than they are now.

Why?

Because the banks will still have the same amount of crap assets on their balance sheets, and they'll have no more capital available to absorb these losses when they hit. The only thing that will change is that the taxpayer will now get hit first as these losses flow through, instead of getting hit second, as is the case now. The banks' bondholders, meanwhile, will still be protected to the tune of 100 cents on the dollar (by administration policy). If the common equity is wiped out by the losses, therefore, the government will have to dig into the taxpayer's pockets to cover any shortfall. (See Paul Kasriel's detailed explanation below).

In other words, Geithner has hatched yet another plan to avoid dealing with the bank problem once and for all.

How would he do that?

As we've argued, we think the best way would have been to seize the banks and restructure them. Since Geithner has opted against the route, however, the next best way would be to convert unsecured bank debt to equity, not just the taxpayers' preferred stock (the taxpayers' preferred stock should have been senior to all the bondholders, but that's spilt milk at this point).

Converting actual debt to equity would give the banks a much bigger cushion with which to absorb losses. It would split the bank ownership up among current common shareholders, taxpayers, and current debtholders, which would help Geithner avoid having to take full control. It would also, finally, stop exposing the taxpayer to further losses.

The idea that bondholders should share the bank pain is finally gaining some momentum. Let's hope that continues in the coming weeks.

Why is Geithner's new plan just "accounting alchemy?" Paul Kasriel of Northern Trust explains:

Consider Balance Sheet One of hypothetical Gotham City Bank. Assets equal liabilities plus

common equity.





But suppose the Treasury believes that Gotham should have a ratio of common equity to total

assets of 10% rather than the 5% it currently has. No problem. Treasury will just convert $5 of

the preferred shares it owns in Gotham to $5 of common equity. This is shown in Balance

Sheet Two. Now Gotham is well capitalized, right? Wrong.

The depositors and the bond holders always were in line in front of the preferred shareholders in case Gotham had to be liquidated. So, moving $5 from the preferred equity category to the common equity category does not make the depositors and bond holders any better off. Are taxpayers any worse off? Not really. If Gotham’s original $5 of common equity was not going to be enough of a cushion to protect depositors and bondholders, then taxpayers were not going to get all of their preferred-share holdings back anyway.

Now suppose that $30 of Gotham’s loans and investments become uncollectible, as shown in Balance Sheet Three. This means that all of Gotham’s common equity has been wiped out. Infact, Gotham now has an equity “deficiency” of $20. No problem, according to Treasury. It will simply convert its remaining $10 of preferred equity to common equity. That won’t cut it in this case.

As shown in Balance Sheet Four, Gotham still has a common equity deficiency of $10. In other words, if Gotham were to be liquidated, there are only $70 of assets to pay off $60 of deposits and $20 of bonds. Either the Treasury would have to come up with $10 of new funds or bondholders would have to take a 50% haircut. If the Treasury wanted to keep Gotham open and with a ratio of common equity to total assets of 10%, Treasury would have to inject $17 of new funds, all of which would be common equity. In other words, Treasury, meaning us taxpayers, would own 100% of Gotham.

In sum, Treasury’s plan to enhance the capitalization of some financial institutions by beating

preferred equity shares into common equity shares is accounting alchemy.