Saturday, October 18, 2008

Hitch Emerges in U.S. Bank Rescue

A logistical snafu is threatening to complicate Treasury's plan to inject $125 billion into nine of the nation's largest financial institutions, prompting a frenzied round of calls between the government and the banks in question. The program, announced Tuesday, is intended to encourage banks to lend again by having the government take equity stakes to build up their capital levels. But in its haste to get the program under way, the Bush administration overlooked a key detail that could hurt the finances of participating banks, which include J.P. Morgan Chase & Co., Goldman Sachs Group Inc. and Citigroup Inc. Awkward Situation People involved in the dispute expect the glitch, which involves the potential issuance of stock, to be resolved over the weekend. Treasury has anticipated formally buying the equity stakes early in the coming week. The glitch represents an awkward moment for the program, which is designed to ease the credit crunch, and highlights the potential pitfalls of moving so fast. "We're aware of the issue and are working with the SEC to address it," a Treasury spokeswoman said. Under the plan, banks are required to issue so-called warrants, which give the government the right to purchase a bank's common stock at a certain price. Since the government may eventually convert those warrants into stock, banks have to at some point register stock to cover the warrants. The banks worry they will be penalized either if they issue new stock immediately or whether they wait. If the banks register shares immediately, such a move could hurt their earnings per share and their "book value per share" because it would increase their number of shares outstanding. Book value is an important measure for banks because it essentially reflects a bank's net worth. Register Now? But if banks don't register the stock now, they will trigger an accounting rule that forces them to treat the warrants as a liability. That means the banks could potentially be forced record a loss if their stock price increases. This condition stems from the legislative language that gave Treasury authority to buy the stakes as part of a $700 billion bailout package. Under the plan, Treasury has the right to buy common stock equal to 15% of its total investment in a firm. The Treasury will get the right to buy shares at the price a firm's stock is trading at on the day Treasury makes its investment. If the stock is trading at, say, $10 per share on the day of the investment and increases to $20, Treasury can make a profit. If the warrants are treated as a liability, that liability could increase if the value of the warrants climbs. When a liability increases in value on a company's books, it has to take that increase as a charge against profit. This would then result in lower retained earnings, which could lessen a bank's net worth and therefore its capital. The issue is not likely to derail the program. The government is trying to figure out some way to resolve the situation and could issue an exemption allowing the banks to treat the warrants as equity, not debt, which would resolve the accounting problem.

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