Paulson’s Bailout Bucks Look Like Debt in Drag: Jonathan Weil

Commentary by Jonathan Weil

Nov. 6 (Bloomberg) — Bankers angling for a slurp at the U.S. government’s bailout trough should be careful what they wish for. Today’s freshly minted capital might become tomorrow’s debt.

How could that be? It turns out the accounting mandarins are looking to redefine the difference between equity and liabilities on corporate financial statements. And, based on what they’ve decided so far, there’s a chance the government’s bailout dough will have to be shown as debt on banks’ balance sheets someday. That would make sense, too.

To date, Treasury Secretary Hank Paulson has allocated $250 billion for government investments in U.S. banks. Those stakes mainly will take the form of preferred stock, which Paulson has said will count in the banks’ Tier 1 regulatory capital. Nine large banks, including Citigroup Inc. and Wells Fargo & Co., will get $125 billion. The rest would be spread among smaller financial institutions.

The cash isn’t quite theirs for the keeping.

As a preferred shareholder, the government gets a 5 percent annual dividend, which jumps to 9 percent after five years and easily could be mistaken for interest. The shares, which carry no voting rights, generally can’t be redeemed for three years. They limit executive pay. They also restrict any dividends for junior preferred and common shareholders in the event that Treasury’s dividends aren’t paid. Those restrictions look a lot like debt covenants.

“It’s debt with an equity skin around it,” says Jack Ciesielski, publisher of the Analyst’s Accounting Observer in Baltimore. “If it walks like debt, and talks like debt, and quacks like debt, it’s debt.”

Debt or Equity

Not under the current rules, though. It used to be easy to distinguish between debt and equity, when capital structures were simpler. Nowadays, companies routinely issue financial instruments that are engineered to look like equity and raise money like debt. The preferred shares designed by Treasury, which are issued without maturity dates, are a classic specimen.

The Treasury’s preferred-stock plan comes just as the Financial Accounting Standards Board and its London-based counterpart, the International Accounting Standards Board, have begun to reexamine the debt-equity issue. At a joint session Oct. 21, the boards agreed to pursue two possible approaches for a proposal to be released as soon as fall 2009.

Under one method, called the basic-ownership approach, the preferred stock issued to Treasury probably would be classified as debt. That’s because the only financial instrument classified as equity would be common stock. Everything else would be an asset or a liability. Specifically, a financial instrument would count as equity if it “is the most subordinated claim” and “entitles the holder to a share of the entity’s net assets.”

In Disguise

The other method, called the perpetual approach, is more complex. The difference is that an instrument would be classified as equity if it lacks a so-called settlement requirement. Viewed that way, the preferred shares issued to Treasury probably would be classified as equity, because they have no maturity date.

The problem with this method is it wouldn’t stop companies from disguising debt as equity. Consider: If the dividend on Treasury’s preferred shares jumped after five years to, say, 90 percent instead of 9 percent, there’s no doubt the banks would feel compelled to pay back the money before the usurious rate kicked in. Yet under the perpetual approach, the preferred stock would qualify as equity anyway.

Even if the accounting boards tried drafting a standard to include this notion of economic compulsion, that might not be feasible. There’s no way to draw the line precisely. A 9 percent rate today might look like a gift to some companies. In a few years or decades, though, it could seem oppressive.

At Odds

It’s understandable why Treasury structured the preferred stock as it did. Paulson wants to boost public confidence in U.S. banks while maximizing the chance of repayment. Those are both fine objectives. They’re also at odds with each other.

If the Treasury were to buy common stock — the ultimate show of confidence in a company — that would make the banks more solvent, and perhaps more inclined to lend their newfound cash for things like 30-year home mortgages. Instead, the banks getting bailout checks will just be more liquid.

There’s some good in that. Although the credit markets remain tight, the rates that banks charge each other for short- term loans have fallen sharply the last few weeks. Still, improved liquidity is no substitute for pure, unfettered capital that can be used at a company’s discretion. Nor does putting the label “capital” on the Treasury’s bailout money make it so.

Let’s call this taxpayer cash what it is — a bridge loan. It will help. It just won’t get the banks very far.

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