Bank bafflement

Original Link: http://krugman.blogs.nytimes.com/2009/04/20/bank-bafflement/

By Paul Krugman

OK, I don’t get the latest bank-rescue idea: converting TARP preferred shares to common equity. It really does seem to fall into the shuffling-the-deck-chairs category.

James Kwak basically does the same analysis I did. Here’s my way of thinking about it: it’s all about seniority.

What, after all, is the purpose of bank capital? It’s to protect the bank’s creditors: equity holders are first in line for any losses, so that creditors only take a hit if losses exceed capital. And that’s why banks have to have adequate capital in order to function.

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.

And that’s why Tier I capital includes preferred as well as common.

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.

So who is supposed to be fooled by this? The markets? The pundits?

There is, I guess, one possible advantage of the move: by increasing the government stake, it means that taxpayers get more of the upside if the government throws money in the banks’ general direction, say by overpaying for toxic assets. But aside from that, nada.