By Binyamin Appelbaum
Washington Post Staff Writer
Tuesday, April 21, 2009
The Obama administration may let more large, troubled banks suspend interest payments on federal aid, allowing firms to rebuild their capital reserves more quickly and thereby limiting the amount of any additional federal aid that may be needed.

The government initially required aid recipients to issue preferred stock that paid interest of 5 percent a year. It would now allow firms to replace some or all of those government-held shares with common stock that pays no interest. Taxpayers would lose the certainty of a guaranteed return, but could profit if the companies’ stock prices increase. The exchanges also would give the government significant ownership stakes in the banks that participate.

Some banks are likely to need additional federal investments. The government plans to announce early next month the results of “stress tests” to determine how much additional capital banks will need to weather the recession. The conversion of preferred shares to common shares does not directly increase capital because banking regulators already count the government’s investments as capital. However, the banks can add the savings from suspended interest payments to their capital, improving their financial position and reducing the amount of any required government contribution.

Citigroup became the first bank to get such a deal last month, when the government agreed to let the company suspend payments on $25 billion in federal aid, saving the New York bank about $1.25 billion a year. Officials said at the time that similar offers could be extended to other banks once the stress tests were complete.

A basic motivation for the plan is that Congress is unlikely to provide more money for the banking industry because of public anger over the original bailout. As a result, the administration wants to let banks maximize the value of the investments already made.

“The preferred is a two-steps-forward, one-step-back measure,” said Karen Shaw Petrou, managing partner of Federal Financial Analytics, because the banks must pay back a portion of the money they get in the form of interest payments.

Another strategy to minimize new federal investment is giving banks six months to raise any needed capital from private investors. The government hopes that the window will be long enough for investors to discover renewed affection for bank stocks.

The Treasury also expects to collect at least $25 billion in repayments of federal aid from the healthiest banks.

In combination with these other strategies, administration officials increasingly believe that the roughly $110 billion remaining from the original $700 billion approved by Congress will be enough to fund any necessary investments in troubled banks.

The conversion plan also could help banks win over investors who have insisted that the government’s money should not count as capital because of the unusual terms imposed in the fall by then-Treasury Secretary Henry M. Paulson Jr. Initially, the investments did not qualify as capital. But the Treasury Department pushed banking regulators to rewrite the very definition of capital to include the type of investment designed by the government.

The money that banks count as capital must be held free and clear. The most basic form of capital is money raised through the sale of common stock. Deposits, for example, cannot be counted as capital because they belong to customers. Neither can money raised through the sale of bonds, because it must be repaid.

In seeking to give banks additional capital, however, the Bush administration chose not to purchase common stock in the companies because it wanted to avoid taking an ownership stake. Instead, the government purchased preferred shares, leaving ownership of the companies entirely in private hands.

Many investors concluded that the government’s investments did not count as capital, because the terms looked too much like a loan, particularly because the interest rate on the preferred shares spikes after five years to encourage repayment. It seemed clear that the government wanted the money back.

Accepting common shares also could help banks meet a regulatory requirement that most capital be in the form of common equity. This requirement generally is easy for companies to meet, but the government’s massive investments have tipped the balance at some troubled banks.