New Preferred Shares to Bolster Balance Sheets

By DEBORAH SOLOMON WASHINGTON -- The U.S. may be able to recapitalize banks without controlling them. In looking to shore up the financial sector, the Treasury plans to make use of a novel financial instrument that will allow it to bolster banks' balance sheets without necessarily taking a controlling stake in those firms, according to people familiar with the matter. Banks that are found by government stress tests to need additional capital will have two choices: raise the money from the private sector, or go back to the government trough. But instead of taking more money, the government expects many banks to exchange the Treasury Department's existing preferred stakes -- which it acquired last year at the height of the financial crisis -- for a new type of preferred share. This new instrument, called a "mandatory convertible preferred" share, gives banks the ability to create common equity as needed. The preferred shares convert to common shares when a bank or its regulator decides they should, or within seven years. Regulators are paying more attention to the common equity each bank holds, in part because it measures what shareholders would have left if a company were liquidated. By keeping the investments as preferred stakes, the government remains a passive investor, helping it defer the tricky question about how active a shareholder it would be. The government only gets voting rights once the shares are converted into common equity. Most importantly, this preferred convertible stock counts towards building the buffers that are required by the Fed to protect against future losses, and that are known as tangible common equity, or TCE. Banks may want to convert their existing stakes into new "mandatory convertible preferred" shares so they can avoid taking additional government money. While the conversion won't give the company more cash, it would satisfy regulators' concerns about the quality of capital at the banks. The maneuver is also a welcome option for the Obama administration, which has worried about the dwindling resources of its Troubled Asset Relief Program, which has about $110 billion remaining. Some firms could still need additional TARP money, which would also come in the form of preferred convertible stock. But government officials believe most banks' capital needs will be met either through raising money privately or exchanging existing TARP shares for new convertible stakes. On Tuesday, Federal Reserve Chairman Ben Bernanke hinted at the concept in testimony to Congress. "To the extent that there are banks that need capital, our hope is that many of them will be able to raise that capital through either private-equity offers or through conversions and exchanges of existing liabilities to strengthen their capital bases," he said. Write to Deborah Solomon at deborah.solomon@wsj.com