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Commentary Last Updated: Mar 2nd, 2009 - 02:00:45

Treasury�s flawed plan for Citigroup and other banks
By Peter Morici
Online Journal Contributing Writer

Mar 2, 2009, 00:18

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Timothy Geithner continues to destroy bank equity with a misguided TARP and vaguely defined Financial Stability Plan. He seemingly doesn�t grasp that he can�t stop a tub with a two inch drain from losing its water with a one inch stopper.

Roughly, the United States has $11 trillion plus in outstanding mortgages. About half are financed or guaranteed by Fannie Mae and other government banks. The balance are non-conforming loans written by commercial banks with varying payment and interest rate structures -- these are held by banks as straight mortgages or bundled into collateralized-debt-obligations (CDOs) held by banks or by fixed-income investors.

As housing prices fall, mortgage losses mount and could easily reach another $1 trillion. Moreover, banks face similar losses on credit cards, auto loans and other questionable loans written during the Great Age of Excess -- a.k.a. the second term of George W. Bush.

Banks must cover those losses by taking charges against their capital, and could deplete their capital and become insolvent. The Treasury�s approach is boost their capital by purchasing preferred shares through the TARP. Essentially, Treasury is selling $750 billion in bonds and using those funds to purchase dividend-paying preferred shares in Citigroup, other commercial banks, large Wall Street securities dealers, and other financial services like AIG.

As housing prices fall, projected defaults and losses rise, and the values of CDOs held by banks fall too. Housing prices are down by 27 percent since August 2006, and the pace of decline is accelerating. Prices could easily fall another 15 or 25 percent.

Already, about $400 billion in TARP funds are committed, and with housing prices dropping faster than Galileo�s rock, the remaining $350 billion will not be enough.

The Treasury is performing stress tests on the 19 largest banks to determine whether their common share equity could cover losses under various scenarios. Citigroup and others will likely come up short if Treasury is honest about how much housing prices could fall.

Bankers usually include preferred shares and other assets when measuring capital adequacy against prospective losses, and by those measures, Citigroup and others remain well capitalized, at least for now.

Treasury has offered banks the option of converting its preferred shares to common stock, eliminating the 5 percent dividend on those shares but significantly diluting private shareholder equity.

At Citigroup, Treasury is offering to convert $25 billion of preferred shares to common stock, if Citigroup suspends dividends to most private preferred shareholders and significant numbers convert to common shares.

Faced with the choice between preferred shares that pay nothing, and high risk common shares worth close to but a bit more than nothing, most are expected to take the plunge.

Together, these ploys essentially confiscate private equity -- a government taking in the meanest sense.

Washington�s stress tests and sacking of Citigroup are motivating general fear among investors, and are driving prices for common stock of most banks into a race to zero. Coupled with the need for much more government funds as housing prices fall, this makes the U.S. government the inevitable controlling shareholder of the nation�s largest banks.

Comrade Stalin was not nearly as stealth.

No solution to preserve private banking can be found without halting the freefall in housing prices. That will require an aggregator or bad bank to purchase about $2 trillion in mortgage-backed securities at current mark-to-market values on the banks books. It could be capitalized with $250 billion in TARP funds, $250 billion in share sales to private shares, and $1 trillion in bonds. Banks and others could be paid for securities with 75 percent in cash and 25 percent in aggregator bank shares.

Performing triage -- leaving alone mortgages that will be repaid, reworking those that could be repaid with some adjustments in principal and interest terms, and foreclosing on the rest -- the aggregator banks could fix the number of foreclosures and limit the fall in housing prices. As many mortgages would be saved, the aggregator bank, like its predecessor the Savings and Loan Crisis Resolution Trust, would likely earn a profit for investors.

The banks, though not free of their other loan problems, would be strong enough to raise new capital, buy back the government�s preferred shares, reform management and lending practices, and contribute to, rather than retard, economic recovery.

Secretary Geithner has other plans few can understand, and whose motivations only the Gods above Mount Olympus can divine.

Peter Morici is a professor at the University of Maryland�s Smith School of Business and is the former Chief Economist at the U.S. International Trade Commission.

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