Obama Bank Nationalization Is Focus of Speculation (Update3)

Feb. 23 (Bloomberg) -- The Obama administration, which says it doesn’t want to nationalize U.S. banks, may find itself taking another step in that direction if it converts the government’s preferred shares in Citigroup Inc. into common equity to help the firm withstand losses.

Citigroup and rival Bank of America Corp., beaten down in New York trading last week on U.S.- takeover speculation, are among more than 20 lenders that could wind up majority-owned by the government if such conversions took place. Executives at New York-based Citigroup have discussed the change as a way to quell concerns about capital adequacy while heading off all-out nationalization, according to a person familiar with the matter.

U.S. regulators led by the Treasury Department announced today that the government stands ready to take bigger bank stakes in the form of shares that “would be converted only as needed over time.” To analysts including Paul Miller of Friedman, Billings, Ramsey Group Inc., nationalization of some of the nation’s largest lenders appears well under way. The government already holds $52 billion of preferred shares in Citigroup, five times the bank’s market value as of Feb. 20.

“We’re already in the nationalization phase,” Miller said today on Bloomberg Television. “We already own a chunk of Citigroup and Bank of America. The problem is that the government is dancing around this nationalization issue. They do not want to do it.”

Stress Test

Citigroup is talking to regulators about expanding the U.S. stake to as much as 40 percent, the Wall Street Journal reported, citing unidentified people familiar with the situation.

Treasury Secretary Timothy Geithner and his fellow bank regulators said today that the government’s proposed “stress test” for the nation’s largest banks would start this week. The test will determine which firms should hold an extra buffer of capital to withstand a more severe economic climate. Those that fail will be given additional taxpayer money if they can’t raise it from the private sector.

Financial firms can apply to convert U.S. preferred stakes into common equity “to strengthen their capital structure,” said Treasury spokesman Isaac Baker, who declined to comment on specific banks. “We are open to considering a request to do so if the institution and its regulator believe it would promote the long-term stability of that institution, and if we believe it’s in the best interest of long-term stability of our economy and financial system,” Baker said.

Roubini, Graham, Greenspan

The idea of nationalizing banks has gained traction in recent weeks as Nouriel Roubini, the economist and professor at New York University’s Stern School of Business, Republican Senator Lindsey Graham of South Carolina and former Federal Reserve Chairman Alan Greenspan all suggested it as a solution to banks’ woes.

Senate Banking Committee Chairman Christopher Dodd said in a Feb. 20 interview with Bloomberg Television that “short- term” government takeovers may be unavoidable.

Bank shares plummeted last week, with Citigroup sinking to an 18-year low of $1.95. Bank of America fell to $3.79, the lowest price since 1984. Both firms gained more than 10 percent today at 9:34 a.m. in New York Stock Exchange composite trading.

Nationalization “is the only way out,” said Miller, of Freidman Billings in Arlington, Virginia. “Losses are just going to accelerate in the next couple of quarters. The holes in these banks are just too big.”

Tangible Common Equity

By converting its preferred shares to common, the government could pad too-thin tangible common equity, or TCE, ratios. TCE strips out intangible assets, goodwill -- the premium above net assets paid for acquisitions -- and preferred stock, including shares issued to the U.S. Treasury. The ratio measures TCE against tangible assets.

“Conversion would make a lot of sense for the banks that are struggling with their tangible common equity ratio, because they cannot go out today and raise common,” said Gerard Cassidy, an analyst at RBC Capital Markets in Portland, Maine, referring to a measure of a lender’s ability to absorb shocks.

Such conversions could be imposed unilaterally under terms of the Troubled Asset Relief Program passed by Congress last fall, which has so far appropriated $300 billion to financial firms. Changing the government’s preferred holdings to common shares would provide a cash infusion to a bank’s lowest tier of capital, boosting its first line of defense against losses.

Preferred stock “is not seen in the investment community as protection against losses,” said Anthony Davis, an analyst at Stifel Nicolaus & Co. in Florham Park, New Jersey.

‘Line of Defense’

The stock is more senior in the capital structure than common shares, so “loan-loss reserves and tangible common equity are the first line of defense,” he said.

If the U.S. were to convert all of its holdings into common shares, it would own more than 80 percent of the company.

Charlotte, North Carolina-based Bank of America, which has received $45 billion in TARP funds in exchange for preferred shares and warrants, would be 66 percent owned by the government if its entire stake were converted to common equity, according to data compiled by KBW Inc., a New York-based investment bank. The figure would be 69 percent at Regions Financial Corp. in Birmingham, Alabama, which has received $3.5 billion from the U.S. It would be 83 percent at Fifth Third Bancorp, the largest Ohio-based lender, which got $3.4 billion.

KBW calculated the government stakes based on a conversion price of 80 percent of the stock’s value as of Feb. 5.

Stricter Scrutiny

Bank of America, Citigroup and Wells Fargo & Co. in San Francisco are among more than 400 financial institutions that have received cash in exchange for preferred shares under the program. They now face increased scrutiny from regulators and investors, who are focused on their tangible common equity.

Bank of America, the largest U.S. bank by assets, said in January that its tangible common equity was 2.83 percent of tangible assets. At Citigroup, it’s only 1.5 percent, according to estimates from Goldman Sachs Group Inc. analysts led by Richard Ramsden. JPMorgan Chase & Co., based in New York, has tangible common equity equal to 3.8 percent of tangible assets.

Institutions have “some discretion” as to what their TCE ratios are, although lenders with tangible common equity below 3 percent of assets should consider raising more capital, said James Barth, a former chief economist at the Office of Thrift Supervision and now a professor of finance at Auburn University in Alabama.

Bank of America has enough “capital, liquidity and earnings power to make it through this downturn on our own,” Chief Executive Officer Kenneth Lewis, 61, said in a Feb. 20 memo to employees. “Bank of America does not need any further assistance today, and I am confident we will not need any further assistance in the future.”

‘Nothing Going On’

The company isn’t talking with the government about expanding its ownership stake, spokesman Robert Stickler said yesterday.

“There is nothing going on with us,” he said. Public policy should be promoting new private capital into the banking system, not discouraging it, he said.

Tim Deighton, a spokesman for Regions Financial, said his bank was also not in danger of nationalization.

“We are approximately $5 billion over what regulators consider to be well-capitalized,” Deighton said, adding that he couldn’t “speculate on reports and conjecture.”

Citigroup spokeswoman Shannon Bell declined to comment, as did Fifth Third spokeswoman Debra DeCourcy.

Neither the $700 billion allocated under TARP last October nor the $787 billion stimulus bill signed earlier this month by President Barack Obama has prevented the 24-company KBW Bank Index from plunging by more than 50 percent this year. Bank of America stock has dropped 73 percent since the beginning of January.

Wipeout

Citigroup, led by CEO Vikram Pandit, has fallen 71 percent, battered by speculation that shareholders would be wiped out if the banks were nationalized.

U.S. financial firms have posted more than $750 billion in writedowns and credit losses since last year as the collapse of the housing market led to the worst financial crisis since the Great Depression. Analysts expect bank losses to increase this year, as asset devaluations spread from mortgage portfolios to consumer loan books and commercial real estate.

Fourteen banks have been seized by state and federal regulators this year after 25 failed in 2008, and as many as 1,000 more may collapse within five years, RBC’s Cassidy said. From 2000 through 2007, only 27 banks were closed, according to the Federal Deposit Insurance Corp.

‘We Need Money’

“It’s the question of, ‘What’s the best way to get this system cleaned up and going again?’” William Seidman, a former FDIC chairman said in an interview. “In my view, you have to nationalize some of the banks to do that. The alternative is they’re losing money, they come back to say, ‘We’re too big to fail, we need money.’ They’ll do that every month.”

The Obama administration strongly believes a “privately held banking system is the correct way to go,” White House spokesman Robert Gibbs told reporters at a briefing on Feb. 20.

Should the government decide to nationalize banks, “it’s going to be very quick,” said Friedman, Billings’s Williams. “I don’t think they’re there yet, but you didn’t know they were there with Fannie and Freddie.”

The government could rewrite its contracts with banks to say “our preferred is now convertible preferred,” Cassidy said. An amendment in the TARP securities purchase agreements allows the government to “unilaterally amend” the terms. At least 30 banks have declined participation in the program, in part because of the rule, which Mark Tenhundfeld, regulatory- policy director at the American Banker Association, called an “open-ended obligation.”

Political Hazard

Although it may be the easiest way to ease capital concerns, “it’s unlikely that nationalization is going to occur,” said Jennifer Thompson, an analyst at New York-based Portales Partners LLC. “It probably ends up doing more harm than good in the long run. There are different ways you can get the same end result without going the nationalization route.”

In addition to wiping out common shareholders, a government takeover of banks may pose political hazards.

“The fear you have of a nationalization is that politicians would allocate bank capital,” said Cassidy. “We all know they’re out for themselves. They’re not out for the national interest. They’re not out for profit-seeking decisions. They’re just out to get elected.”

To contact the reporter on this story: Linda Shen in New York at lshen21@bloomberg.net

To contact the editor responsible for this story: Rick Green at rgreen18@bloomberg.net.