Nationalizing the Banks? Stock Conversion May Backfire

The Obama Administration wants to convert the preferred shares the government got from banks in the bank bailout into common shares. In theory, it could help expand lending, but in practice, it could politicize the banks, harm the economy, and waste taxpayer money.

Common shares, unlike preferred shares, vote on who manages the company. The Government could use its votes to make banks waste money on ideological causes — the way it recently did with Freddie Mac, in order to promote mortgage relief for even high-income borrowers, and is now attempting to do with banks that lent to automakers, in order to bail out the UAW union. Or it could use its new power over corporate management to bail out politically connected Wall Street firms — as it did with the AIG bailout, gave billions of dollars to wealthy customers of AIG like Goldman Sachs, a wealthy Wall Street firm which was in little danger of going bankrupt, but which gave millions to liberal politicians, and which was formerly headed by Bush’s last Treasury Secretary.

On the other hand, preferred stock gets paid dividends before common stock. One of the ideas behind conversion is to increase banks’ cushion of common stock, and thus dilute future losses by common shareholders. The theory is that this will make bank managers less reluctant to lend money for fear of losses. Conversion could also reduce troubled banks’ burden of paying preferred dividends, and give the government more incentive to make banks profitable. For this reason, some banks apparently like the idea of conversion.

But there are big pitfalls in practice, since common shares, unlike preferred shares, vote on who manages the company. The Government could use its votes to make banks waste money on ideological causes — the way it recently did with Freddie Mac, in order to promote mortgage relief for even high-income borrowers, and is now attempting to do with banks that lent to automakers, in order to bail out the UAW union. Or it could use its new power over corporate management to bail out politically connected Wall Street firms — as it did with the AIG bailout, gave billions of dollars to wealthy customers of AIG like Goldman Sachs, a wealthy Wall Street firm which was in little danger of going bankrupt, but which gave millions to liberal politicians, and which was formerly headed by Bush’s last Treasury Secretary.

It’s not clear whether the government will negotiate with banks, or follow normal contractual provisions, as to the rate of conversion, or whether it will use financial pressure. Many healthy banks were strong-armed into accepting TARP bailout funds in the first place, so that banks that really needed a bailout would not be stigmatized by accepting the funds. Now, the government doesn’t want them to be allowed to return the unnecessary funds in order to escape micromanagement of their business practices. Nor does the Administration seem to have an exit strategy to sell shares when the economy recovers, to keep banks from being subject to destructive political meddling and corruption, the way parastatal companies long were in Italy.

As the New York Times notes, after converting its preferred stock into common, “The Treasury would also become a major shareholder, and perhaps even the controlling shareholder, in some financial institutions. That could lead to increasingly difficult conflicts of interest for the government, as policy makers juggle broad economic objectives with the narrower responsibility to maximize the value of their bank shares on behalf of taxpayers.”

Freddie Mac offers a cautionary tale of what happens when the federal government takes over a financial institution. After federal regulators took over failing mortgage giant Freddie Mac, they didn’t stop its risky lending practices. Instead, they ramped up its risk-taking, making it run up even bigger debts at taxpayer expense to try to artificially pump up the economy. They made Freddie buy countless risky mortgage loans. Recently, the Obama Administration forced it to incur $30 billion in losses as part of the administration’s bailout for irresponsible mortgage borrowers, which caps mortgage payments for even high-income borrowers at a ridiculously low level. The Obama Administration tried to prevent Freddie Mac from even disclosing these losses in the financial disclosures it must make to investors under the securities laws.

I was a huge critic of GSEs like Freddie Mac and Fannie Mae. CEI President Fred Smith publicly criticized their risky practices for years. Congress ignored his prophetic warnings about the risk they posed to taxpayers. But federal regulators have been so reckless that they have managed to make matters even worse at Freddie Mac.

Obama’s car czar, Steven Rattner, is pressuring banks to satisfy the Administration’s costly political goals at the expense of shareholders and taxpayers. As Michael Barone notes, “The banks that have received federal TARP funds—some unwillingly—were told by government car czar Steven Rattner that they must accept 15 cents on the dollar on some $7 billion (face value) of Chrysler bonds. They professed shock and refused.” The reason for this demand is that absent such concessions, Chrysler won’t be taken over and bailed out by Italian carmaker Fiat unless the UAW union is willing “to give up some of the supergenerous health care benefits and supergenerous pension arrangements that the UAW has extracted from the U.S.-based automakers over the years.” Rattner, a major liberal donor, wants to keep such cost-cutting from happening at all costs, in order to benefit the staunchly liberal UAW — even though doing so will cost U.S. taxpayers billions.

Given its poor track record of financial management, such as record deficits, there is little reason to believe that the Administration can run banks better than their current managers, however mediocre. The Administration is spending $800 billion on a stimulus package designed to revive the economy, but the Congressional Budget Office says the “stimulus” will actually shrink the economy “in the long run.” And Treasury Secretary Geithner has a history of bungling responses to past economic crises, such as his role in the destruction of Indonesia’s economy in the Asian Financial Crisis of the 1990s.