An article yesterday sets out details of a new U.S. Treasury Department program pursuant to which capital injections will be made into the 19 largest U.S. banks based on a “stress test”.

In summary, the 19 banks will have six months to raise private capital after a review of their financial statements before they can be eligible for new (i.e. incremental to government advances already made) capital injections. Under this approach government regulators are looking at each financial institution’s balance sheet and evaluating how much capital will be needed over the coming two years. This process is expected to be completed by April 30. Based on its analysis, the government would let institutions exchange taxpayer-funded preferred shares for common shares when losses forecast by the stress test actually occur.

To evaluate whether banks need capital infusions, the article says the Treasury Department has designed two economic scenarios to estimate expected losses over the next two years. Apparently government officials will take into consideration a financial institution’s projected losses or profits based on a pair of alternate economic forecasts for 2009 and 2010 that look at GDP growth, unemployment rates and other factors. One forecast is expected to reflect a “deeper and longer” recession scenario. The forecast will also take into account changes to the residential house prices for 2009 and 2010. The 19 banks will be asked to analyze their loan and securities portfolios to estimate their future losses under each of the two scenarios. The banks that have received the convertible shares will be able to exchange them for common stock with regulatory approval at a price that is a 10% discount to the “prevailing level of the institution’s stock price as of Feb. 9, 2009.”

The article says existing common shareholders of the 19 banks are concerned about this plan because:

• preferred shares rank higher in the capital structure of a company than do common shares. In the event that a firm goes bankrupt and is liquidated, preferred shareholders could be in line to collect something, while common holders likely would get nothing; and,

• conversion of preferred shares into common shares would make currently existing shares worth less through dilution. In other words, the more shares of common stock outstanding, the less valuable each common share is.

My Comments: First, the concerns the article expresses on behalf of existing common shareholders of these banks are ridiculous. An inherent risk of holding common shares in any company is that if the company is unsuccessful its common shares may be worth little or nothing, and if new capital is infused common shareholders almost inevitably get diluted. If the common shareholders of these 19 banks really believe these things, and have spokesmen voicing these types of concerns, they ought to have a stiff drink and drown their sorrows in the reality of their common share ownership positions. Second, I find the concept of alternate forecast scenarios interesting. I would like to know whether there will be open disclosure of the ‘GDP growth’, unemployment rates, housing prices, and ‘other factors’ that are adopted in these forecasts. I wonder whether in all the current economic circumstances it makes any sense to forecast ‘GDP growth’ as contrasted with ‘GDP retraction’. I would also like to know whether the U.S. Administration has a contingency plan in the event the ‘worst case’ forecasts for each bank prove to be optimistic. My current thinking is that the degree of U.S. government interference in the private sector banking industry is a recipe for disaster, and is completely contrary to the ‘capitalism concept’ that served America well for many decades.

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