Bloomberg acknowledges the obvious:

April 27 (Bloomberg) -- U.S. banks that received results of their federal stress tests last week were given three options if they need additional capital to withstand the recession. The reality is they may only have one.

Getting federal aid or selling shares -- two of the choices offered to the 19 lenders being tested -- aren’t practical politically or financially, according to analysts. . . .

That leaves the third option presented by Treasury Secretary Timothy Geithner: changing the preferred stock held by the U.S. Troubled Asset Relief Program into common shares. [Emph. added]

Well, yes. Stress-tested banks that need to raise new capital will have no choice but to do so by diluting the bejeezus out of their existing shareholders via conversion of their TARP preferred into common. What’s the alternative? Congress isn’t about to make a new round of TARP money available. And private investors have become, ahem, leery of investing alongside the federal government.

That leaves conversion. It will be a pointless exercise that will do nothing to buttress a bank’s finances, and will cost shareholders a bundle. The banks won’t receive an additional new dollar of cash, remember; all that will happen instead is that a slice of the bank’s capital base will be re-labelled “common” from “preferred.” What good that is supposed to do, I can’t imagine.

You’ll forgive me if I sound a little cranky about this whole process. It’s occurring because regulators, as they indicated in the stress-test white paper they released last week, continue to feel common equity should make up a “dominant” portion of a bank’s capital base. It’s not at all clear why that’s supposed to strengthen a bank’s ability to withstand losses. (I’ll explain why in a minute.) Regulators say they haven’t changed the ratios banks need to hit to be considered “well-capitalized;” they’ve only changed the mix of what should make up that capital.

It’s all part of the new Cult of Common Equity sweeping through the banking business. Emblematic of the cult is a hitherto obscure financial ratio, tangible equity to total assets, that has for some reason become the metric bank watchers now believe to be the single most reliable indicator of a bank’s financial health, even though for years it’s been irrelevant to regulators. (As far as that goes, the regulators scarcely mentioned tangible common equity in that white paper they put out on Friday.) 

But common equity is now supposed to be crucial, the conventional wisdom believes, because common equity, and only common equity, “takes the first loss.”

Common equity takes the first loss? That statement is notable because a) it’s not true, and b) it’s beside the point--which ought to tell you something about the state and quality of the whole capital debate these days. First off, common equity does not take the first loss. Earnings do. Wells Fargo (to pick one institution at random) has pre-tax, pre-provision earnings power of roughly $10 billion per quarter. As the company moves to charge off nonperforming assets in the coming quarters and years, that future earnings power is what will absorb the blows. The company’s common equity account figures to grow, via rising retained earnings, as that process goes along.  

But more to the point, who cares who takes the first loss? Bank regulators (i.e., the people running the stress tests) shouldn’t. They really only care who takes the last loss. And what they care about in particular is that the last loss doesn’t fall on the depositors or the FDIC insurance fund.

Short of that, regulators, once they’re satisfied that a bank is adequately capitalized and has sufficient liquidity, should in theory be indifferent to which investors who takes the credit hit, or in what order. In the real world, the sequence goes like this: ongoing earnings, common equity holders, preferred equity holders, and non-federally-guaranteed debt holders. Only once all those slices get burned up is the federal government on the hook. 

This should be obvious. Instead, the discussion of how banks should book loan losses is becoming surreal. Here’s what the New York Times, anticipating the stress-test results, said on Saturday: “Federal officials said that some banks might need to raise additional capital. Others might need to change the form of their existing capital by converting preferred shares into common stock, which is better at absorbing losses.” [My emphasis]

That is—what’s the word?—insane. One slice of a bank’s capital isn’t “better” at absorbing losses than another is. The arithmetic is ridiculously easy, and it applies to every piece of the capital base the same way. It’s simple subtraction. Yet the common equity crowd has convinced itself (and, worse, regulators, it seems) that banks need to bulk up on common equity that can be available to take some theoretical “first loss” that, from a regulatory standpoint, ought to be entirely beside the point in any event. Worse, the effect of this ham-handed mandate will be to make it harder for banks that actually do need to raise fresh capital to find willing private investors. 

The new emphasis on common equity is irrelevant to what ails the banking system, and is making fixing the system harder, not easier. Shareholders are being needlessly diluted, to no benefit. And institutions that will need to raise substantial amount of new capital will have a harder time doing so than they should. All on account of a number that no one cared about until recently. It’s nuts.

What do you think? Let me know!