Equity Stakes

Speaking to a Congressional panel today, Treasury Secretary Geithner advanced the idea of converting the government's preferred equity stakes in banks into common equity. Preferred stock is actually more like debt than stock because companies pay a fixed coupon to holders of preferred shares. By converting preferred shares to common equity, the Treasury hopes to reduce the liabilities of troubled banks and thus improve their capital position. The media, along with many politicians, have correctly identified this as a risky idea. But most of the scrutiny has focused on the thorny issue of how the government can effectively control large ownership stakes in corporations. Fears of nationalization and government interference in private markets have been at the heart of the debate about converting government stakes to comon equity.

Such fears are valid. But they should not be the focus of the debate. First of all, the government already has control over bailout recipients. Many banks would be bankrupt without government assistance. If the government wants to interfere, it can already do so simply by threatening to cut off funding. So fears of nationalization or excessive government interference are moot. Second, and most importantly, the real problem is that common equity is much riskier than preferred equity. A preferred share must pay a fixed coupon to the investor unless the company suspends the dividend it pays to common shareholders. In other words, preferred share holders get paid before common equity holders. Preferred stock holders also fare better if bankruptcy occurs and the firm is liquidated. Congress and the media should be giving more attention to how the conversion would increase the government's probability of losing money. The Treasury has already put trillions of taxpayer dollars at risk to help banks. Converting preferred shares to common equity will exacerbate the problem.