Conversion Convention

Building off last night's post on the government converting its stake in Citigroup from preferred to common stock as a back door for Plan N, this article in Bloomberg News takes a look at several scenarios for Plan N's implementation.

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.”

Of course they don't want to do it. But I've been saying they have no choice now for months. So, what happens if the TARP funds Citigroup and other banks have been given were converted to common stock for the government?

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.

Voila. Nationalization through the back door. It's going to have to be done. Looks like majority government ownership of the banks, temporary as it may be for now, is imminent.

Here's the real question: How will the government be able to re-privatize the company without annhiliating the stock price and the value of the company? It's not going to able to do so. For the most part, when the government takes over, it's going to have no choice but to break up the banks it eats.

None of these nationalized banks will survive. Assets will be sold off to those banks that are above water...the real problem is that the banks that are above water now won't be for much longer as housing prices, commercial real estate prices, and mortgage defaults continue to pile up, and the rest of the economy tanks.

It's not that some banks are good and others bad, it's that some are clearly insolvent and some haven't collapsed yet, but will over the course of the next year.