US U-turn on tangible common equity | FT Alphaville

US U-turn on tangible common equity

Here is your bitter-sweet good news of the morning, from the Wall Street Journal (HT Rolfe Winkler):

Citigroup Inc. is in talks with federal officials that could result in the U.S. government substantially expanding its ownership of the struggling bank, according to people familiar with the situation.

While the discussions could fall apart, the government could wind up holding as much as 40% of Citigroup’s common stock. Bank executives hope the stake will be closer to 25%, these people said.

Right, right, another bank nationalisation. But here’s the interesting part:

Under the scenario being considered, a substantial chunk of the $45 billion in preferred shares held by the government would convert into common stock, people familiar with the matter said. The government obtained those shares, equivalent to a 7.8% stake, in return for pumping capital into Citigroup.

That’s effectively a U-turn on government capital injections, which have so far come in the form of preferred equity instead of common stock.

And wait, there’s more.

As part of the plan, Citigroup officials hope to persuade private investors that have bought preferred shares – such as the Government of Singapore Investment Corp., Abu Dhabi Investment Authority and Kuwait Investment Authority – to follow the government’s lead in converting some of those stakes into common stock, according to people familiar with the matter. That would further bolster an obscure but increasingly pivotal measure of banks’ capital known as “tangible common equity,” or TCE.

The TCE measurement, one of several gauges of a bank’s financial strength, gives weight to common shares – thus the interest in converting preferred shares to common stock…

There are at least two catalysts for the recent talks with the government.

First, Citigroup’s shares have fallen to historic lows. That doesn’t pose a direct threat to the company’s stability. But if it spooks customers into pulling their business, that could push the bank toward a dangerous downward spiral.

Second, bank regulators this week will start performing their battery of stress tests at the nation’s largest banks as part of the Obama administration’s industry-bailout plan. As part of those tests, the Federal Reserve is expected to dwell on the TCE measurement as a gauge of bank health, according to people familiar with the matter.

The crisis is triggering a deep re-examination of the way bank health is measured in the U.S. financial system. This complex exercise boils down to calculating various ratios of capital to a bank’s total assets.

Until recently, TCE – essentially a gauge of what common shareholders would get if an institution were dissolved – has been one of the less prominent ways to measure a bank’s vigor. TCE is also among the most conservative measures of financial health.

Bankers and regulators generally prefer to use what is known as “Tier 1″ ratio of a bank’s capital adequacy. It takes into account equity other than common stock. By Tier 1 measurements, most big banks, including Citigroup, appear healthy. Citigroup’s Tier 1 ratio is 11.8%, well above the level needed to be classified as well-capitalized.

By contrast, most banks’ TCE ratios indicate severe weakness. Citigroup’s TCE ratio stood at about 1.5% of assets at Dec. 31, well below the 3% level that investors regard as safe.

The regulators’ new focus on TCE represents an important shift. The government’s recent injections into hundreds of institutions were predicated on the idea that Tier 1 was key. Because the investments weren’t in the form of common stock, they didn’t affect the companies’ TCE ratios.

It’s probably not a coincidence that the US U-turn on preferred vs common stock is coming in relation to Citigroup specifically. In addition to being a “more conservative” measure of bank capital, TCE also backs out intangible assets like deferred tax credits — of which Citi has a lot.

Those deferred tax credits (which we speculated were a prime reason for selling brokerage Smith Barney to Morgan Stanley) have helped Citi maintain its Tier 1 ratio at a “well-capitalised” 11.9 per cent, according to the bank’s CEO, Vikram Pandit. The reality, as the market seems to know, having halved Citi’s shares over the past week, is that Tier 1 ratios are full of fluff like deferred tax credits — and by these fluffy measures banks are doing just fine. Only, clearly, they’re not.

So, it’s very good news that the US will be looking at TCE when stress-testing banks. It’s a bit more bitter-sweet that this new focus comes only after the government’s already ploughed something like $235bn into the banks in the wrong form of capital — preferred shares. Oh, and it’s also bitter-sweet since by TCE measures, as noted in the reference to Citi’s TCE ratio in the WSJ story above, most banks are likely to need a lot more capital.

Related links:
Tangible common equity – Option ARMageddon
Tangled tangibles
– FT Alphaville
Citi of over-leveraging – FT Alphaville
Wanted: $1,000,000,000,000 to bailout the US financial system – FT Alphaville