IMF: Government Borrowing Is Rising Risk to World Financial System

GLOBAL FINANCIAL STABILITY REPORT
By James Rowe
IMF Survey online
April 20, 2010
-Projected losses shrinking among banks
-Government risk is new threat to prolonging financial crisis
-Credit recovery will be slow
The global financial system and the world economy are slowly regaining their health, thanks in large part to unprecedented interventions by governments, but the sharp rise in government debt during the economic crisis from already elevated levels helped create what the IMF says is the newest threat to the financial system: growing sovereign risk. That is not to say that the private financial sector is fully recovered. Indeed, the recovery in the financial sector remains “fragile,” according to José Viñals, Financial Counselor and Director of the IMF’s Monetary and Capital Markets Department.
Bank balance sheets still contain bad assets, consumers and businesses remain stretched, and credit recovery is some time off, the IMF said in its latest Global Financial Stability Report (GFSR), released April 20. Moreover, a large part of the financial system continues to rely in varying degrees upon the extraordinary measures governments began to introduce two years ago—such as purchasing bad assets from, and injecting capital into, troubled institutions.
Heavy sovereign borrowing
But the biggest threats have moved from the private to the public sectors in advanced economies. Governments not only took on many of the bad assets from private institutions but due to the recession face continuing heavy borrowing needs for the next few years. Slow growth in the real economy and high unemployment will retard tax revenues and require higher government spending—such as on unemployment benefits and job creation activities.
“In spite of recent improvements in the outlook and the health of the global financial system, stability is not yet assured,” Viñals said a news conference April 20. “If the legacy of the present crisis and emerging sovereign risks are not addressed, we run the very real risk of undermining the recovery and extending the financial crisis into a new phase.”
In a wide-ranging assessment of the state of the global financial conditions, the IMF report said:
• Improving economic and financial conditions have helped private bank balance sheets in advanced economies. The IMF sharply reduced its estimate of the writedowns or loan loss provisions banks will have to take—or have taken—to account for bad loans and securities on their books. The improving quality of bank assets means that banks will probably need less capital than previously estimated to absorb losses. But banks still will face funding difficulties in the next few years, as their bonds mature and the special government assistance programs are withdrawn.
• Credit recovery will be “slow, shallow and uneven,” as heavy government borrowing soaks up available funds and banks continue their reluctance to lend to repair their balance sheets.
• There is little evidence, at least so far, of bubbles in asset prices in emerging markets, despite strong portfolio flows to Asian and Latin American countries from investors seeking higher returns.
• Authorities must address a number of policy issues, including how to manage borrowing and spending to minimize sovereign risk.
The IMF warned that the increase in sovereign risk can hit banking systems and the real economy that produces goods, services, and jobs. Even with weaker private credit demand, governments could crowd out business and household borrowers, retarding recovery.
Moreover, if jittery investors worried about long-run government solvency cause a decline sovereign bond prices in the advanced economies, still-recovering banks, which are major investors in government debt, could face new hits to the value of assets on their balance sheets. And rising interest rates on public debt could also flow through to the private sector raising borrowing costs for businesses, consumers, and banks.
Banks improve
This potential underscores the fragility of the recovery in the banking sector, which has shown great improvement since the last GFSR was issued by the IMF in October 2009.
The latest report said that the global banking system—which two years ago faced severe funding difficulties compounded by a lack of confidence among all market participants—is recovering. “Improving economic and financial market conditions have reduced expected writedowns and bank capital positions have improved substantially.”
The report cut its estimates of writedowns of bad loans and securities that banks—mostly in Europe, the United Kingdom, and the United States— will have to take during the period 2007 to 2010 from $2.8 trillion last October to $2.3 trillion (see table). Banks already have written off about $1.5 trillion of the $2.3 trillion, the IMF estimates.

Issues on the liability side of the ledger
Although the asset side of bank balance sheets is improving, the liability side may come under increasing pressure in coming months. It is clear that banks have improved their capital positions substantially, from private investors and increased earnings. And improvements in the asset picture mean less pressure on boosting capital buffers to absorb potential loan and security losses. But authorities are likely to strengthen bank capital and liquidity requirements to increase the safety of the financial system. And banks must refinance nearly $5 trillion in debt that will mature in the next three years. “This will coincide with heavy government issuance and follow the removal of central bank emergency measures,” the report said. Moreover, the overall picture masks some problem areas, the IMF said. There are problem pockets in regional banks with heavy real estate exposure in the United States; among Spanish banks, which are heavily exposed to real estate development loans; and in some regional banks in Germany. Troubled banks often bid up rates to attract funds which can then squeeze profit margins for healthier banks.
Credit recovery will be slow
Although the worst of the credit contraction may be over, banks are unlikely to boost lending substantially in the near term—both because of the continuing overhang of bad assets that remain on their books and the funding pressures they will face. Moreover the withdrawal of the special government support will further constrain bank lending.
Although private credit demand remains modest—households and businesses continue to reduce their debt levels—sovereign borrowing threatens to overwhelm it, potentially driving up interest rates, forcing private demand to shrink, or both.
No bubbles so far
A number of emerging markets and some advanced economies have become attractive opportunities for investors in most advanced economies, where returns are low and liquidity is high because of policies to support the financial sector and the real economy. Capital has flowed to countries such as Brazil, China, India, and Indonesia—as well as their trading and financial partners—which are perceived to have better cyclical and structural growth prospects.
Although these strong capital flows can create an environment conducive to strong increases in prices of assets such as real estate and equities, so far there is no evidence that these assets have been seriously and unsustainably overvalued, which could lead to the types of price bubbles that preceded the global crisis. Expansionary policies could fuel asset price inflation and the issue for policymakers is managing the consequences of these inflows. In an analytical chapter to the GFSR released April 13, the IMF explored the issues and policy options related to capital flows.
Policy implications
To keep the global financial system on its path to recovery, and manage the risks it faces, policy makers must consider a wide variety of issues.They include
• Carefully managing their budget deficits to ensure that they can sustain their fiscal policy over the medium term to avoid extending the crisis into a new phase.
• Ensuring a smooth deleveraging process that results in a vital and sound financial system that is of the right size, able to provide an adequate flow of credit to the private sector.
• Employing a wide range of tools, including macro-policy adjustments and prudential measures, to address the risks from strong portfolio inflows.
• Continue pushing for policies and regulatory reforms to improve capital and liquidity buffers, to enhance risk management, to reduce the likelihood and costs of the failure of a system institution, and to address the issue of too-important-to-fail institutions.

Banks With 20% Unpaid Loans at 18-Year High Amid Recovery Doubt

By James Sterngold, Linda Shen and Dakin Campbell
Oct. 2 (Bloomberg) -- The number of U.S. lenders that can’t collect on at least 20 percent of their loans hit an 18-year high, signaling that more bank failures and losses could slow an economic recovery.
Units of Frontier Financial Corp.,Towne Bancorp Inc. and Steel Partners Holdings LP are among 26 firms with more than one-fifth of their loans 90 days overdue or not accruing interest as of June 30 -- a level of distress almost five times the national average -- according to Federal Deposit Insurance Corp. data compiled for Bloomberg News by SNL Financial, a bank research firm. Three reported almost half of their loans weren’t being paid. While regulators may not force firms on the list to close, requiring them to raise capital and curb loans may impede recovery in Florida, Illinois and seven other states. The banks are among the most vulnerable of a larger group of lenders whose failures the FDIC said could cost $100 billion by 2013. “There are some zombie banks out there,” said Bert Ely, chief executive officer at Ely & Co., a bank consulting firm in Alexandria, Virginia. “Neither the banking industry nor the economy benefits from keeping weak banks in business.” Ninety-five banks have failed this year at the fastest pace in almost two decades, depleting the FDIC’s insurance fund. The agency proposed on Sept. 29 that financial firms prepay three years of premiums, which would add $45 billion of reserves. The fund sank to $10.4 billion as of June 30, the lowest since 1993. It will run at a deficit starting this quarter, the agency said.
Non-Current Loans
The cost of this year’s failures to the FDIC equals 25 percent of the banks’ assets, according to agency data. Applying the same ratio to the $14.1 billion of assets held by the 26 lenders on SNL’s list means the FDIC could face additional losses of $3.5 billion. Non-current loans averaged 4.35 percent of the total at U.S. banks as of June 30, the most in 26 years of FDIC data. Regulators typically take notice at 5 percent, according to Walter Mix, a former commissioner of the California Department of Financial Institutions. Corus Bankshares Inc.’s bank unit in Chicago was shut Sept. 11 after 71 percent of its loans soured. The last time so many banks had 20 percent of their loans more than 90 days overdue was in 1991, near the end of the savings-and-loan crisis, when there were 60, according to an SNL analysis of FDIC data. That year the number of bank failures was less than half those at the peak of the crisis in 1988; this year closings are almost four times what they were in 2008. For banks with 20 percent of loans overdue, “either they’ve got a massive amount of capital, or the FDIC just hasn’t gotten around to them,” said Jeff Davis, an analyst with FTN Equity Capital Markets in Nashville. Lack of staff and money are slowing shutdowns, he said.
Enforcement Orders
At least 17 of the 26 banks have been hit with civil penalties or enforcement orders that demand improved management and more capital, according to data compiled by Bloomberg. Failure to comply can lead to seizure. The number of distressed banks is larger, with the FDIC counting 416 companies on its confidential list of “problem” lenders at mid-year. The data were compiled by Charlottesville, Virginia-based SNL from FDIC records. Institutions that had loans less than 50 percent of assets were excluded, as were those closed since the end of June. The calculation didn’t include restructured loans modified after borrowers couldn’t keep up with the original terms, which have default rates of 40 percent to 60 percent within two months, according to SNL senior analyst Sebastian Hindman. Had such loans been included, the list would have swelled to 49 lenders holding $48.4 billion in assets.
Local Impact
Firms range in size from Frontier Bank in Everett, Washington, with $3.98 billion in assets, to Gordon Bank in Gordon, Georgia, with $35 million in assets. Six of the banks are in Florida and five in Illinois. “While these aren’t your giant banks, they are the guys your local strip mall and commercial real estate investors get their funds from,” said Joseph Mason, a Louisiana State University banking professor and visiting scholar at the FDIC. The bank with the highest level of non-current loans, 49 percent, is Community Bank of Lemont in Lemont, Illinois, a town of about 13,000 people 30 miles southwest of Chicago. Bad loans at the bank, about a third of them in construction and development, increased fivefold from a year earlier, according to FDIC data. In February, the FDIC ordered Lemont, a unit of Oak Park, Illinois-based FBOP Corp., to stop “operating with management whose policies and practices are detrimental to the bank and jeopardize the safety of its deposits.” Calls to the bank seeking comment weren’t returned.
’A Surprise’
Another Illinois lender, Benchmark Bank, also had an increase in non-current loans, to 25 percent as of June 30 from about 1 percent a year earlier. “Everything was so positive for so long in this area, it came as a surprise when it stopped,” said John Medernach, Benchmark’s CEO, who added that a building boom and bust in his region may have wrecked more than just his balance sheet. “I stop and think of all the rich farmland that has been developed into subdivisions during the boom years,” Medernach said. “It makes you wonder what we’ve been doing.” Frontier Bank, owned by Frontier Financial, reported a sixfold rise in overdue loans to $764.6 million in the quarter ended June 30 from a year earlier, or 22 percent, according to FDIC data. More than 43 percent of the bank’s delinquent loans were in construction and development, FDIC data show. The bank has 51 branches in northwestern Oregon and western Washington.
Steel Partners
In July, Frontier Financial agreed to be acquired by SP Acquisition Holdings Inc., controlled by CEO Warren Lichtenstein, who heads the New York-based investment firm Steel Partners LLC, according to a presentation on the bank’s Web site. The deal would give Frontier access to about $456 million and create ’’an over-capitalized bank’’ that may consider acquisitions, the presentation said. The stock-swap transaction is scheduled to be completed in the fourth quarter. Frontier “was a well-run organization for the majority of its history,” said Jeffrey Rulis, a banking analyst at D.A. Davidson & Co. in Lake Oswego, Oregon. The offer by SP Acquisition is “probably not what current shareholders envisioned a couple of years ago.” The company’s stock has dropped 92 percent in the last 12 months, and the bank posted an $84 million loss in the first half. Patrick Fahey, Frontier’s CEO, said the transaction will resolve the bank’s credit issues. He declined to elaborate while a shareholder vote is pending.
Regulatory Art
Lichtenstein’s Steel Partners Holdings LP controls WebBank, a Salt Lake City lender with $35.5 million in assets and 31 percent of its loans overdue, according to SNL. More than 90 percent of construction and development loans weren’t current as of June 30, according to the FDIC. John McNamara, WebBank’s chairman and a managing director at Steel, declined to comment.
Determining which banks to close is “more of an art than a science,” said William Ruberry, spokesman at the Office of Thrift Supervision, which regulates four of the 26 lenders. “Examiners and the supervisory people have a lot of information that’s not public, and they know the circumstances of an institution and everything that goes into it.” FDIC spokesman Greg Hernandez said in an e-mail that the agency doesn’t comment on individual institutions. Capital levels, profitability and financial strength of the owners are considered in addition to soured loans when deciding a bank’s fate, Hernandez said.
Sources of Capital
“There may be personal guarantees, there may be other collateral that will more than make up for the impairment on the 20 percent,” said Tom Giallanza, assistant superintendent for the State of Arizona Department of Financial Institutions, in a Sept. 15 interview. One bank on the list, Mesa, Arizona-based Towne Bank of Arizona, is in Giallanza’s state, with 28 percent of its loans non-current. Towne Bancorp CEO Patrick Patrick declined to comment. H&R Block Bank, with 29 percent of its loans overdue, is dwarfed by the Kansas City, Missouri-based tax preparer that owns it. The bank’s deposits totaled $720.1 million as of June 30; assets at the parent company, H&R Block Inc., included more than $1 billion in cash and cash equivalents on July 31. The lender’s balance sheet is strong enough to be considered “well- capitalized” by regulators, according to FDIC reports. The bank is a legacy of H&R Block’s subprime home lending that ended with more than $1 billion of losses for the parent company. The unit was kept open because it’s an inexpensive way to fund the company’s financial products, President Russell Smyth said a year ago. Spokeswoman Elizabeth McKinley didn’t respond to requests for comment.
Pace of Closures
Regulators may be pacing themselves on closings because the FDIC fund “is only so big,” there isn’t enough staff to close all the struggling banks at once and customers aren’t staging mass withdrawals that would force action, said Kevin Fitzsimmons, a managing director at Sandler O’Neill & Partners LP, a New York brokerage firm specializing in banks.
While a high level of non-performing assets doesn’t mean a bank can’t survive, “in some cases it creates a hole that’s too deep to climb out of,” Fitzsimmons said.
To contact the reporters on this story: James Sterngold in New York at jsterngold2@bloomberg.net; Linda Shen in New York at lshen21@bloomberg.net; Dakin Campbell in San Francisco at dcampbell27@bloomberg.net.

US credit shrinks at Great Depression rate prompting fears of double-dip recession

Both bank credit and the M3 money supply in the United States have been contracting at rates comparable to the onset of the Great Depression since early summer, raising fears of a double-dip recession in 2010 and a slide into debt-deflation.

By Ambrose Evans-Pritchard, International Business Editor
14 Sep 2009

Professor Tim Congdon from International Monetary Research said US bank loans have fallen at an annual pace of almost 14pc in the three months to August (from $7,147bn to $6,886bn). "There has been nothing like this in the USA since the 1930s," he said. "The rapid destruction of money balances is madness." The M3 "broad" money supply, watched as an early warning signal for the economy a year or so later, has been falling at a 5pc annual rate. Similar concerns have been raised by David Rosenberg, chief strategist at Gluskin Sheff, who said that over the four weeks up to August 24, bank credit shrank at an "epic" 9pc annual pace, the M2 money supply shrank at 12.2pc and M1 shrank at 6.5pc. "For the first time in the post-WW2 [Second World War] era, we have deflation in credit, wages and rents and, from our lens, this is a toxic brew," he said. It is unclear why the US Federal Reserve has allowed this to occur. Chairman Ben Bernanke is an expert on the "credit channel" causes of depressions and has given eloquent speeches about the risks of deflation in the past.

He is not a monetary economist, however, and there are indications that the Fed has had to pare back its policy of quantitative easing (buying bonds) in order to reassure China and other foreign creditors that the US is not trying to devalue its debts by stealth monetisation. Mr Congdon said a key reason for credit contraction is pressure on banks to raise their capital ratios. While this is well-advised in boom times, it makes matters worse in a downturn. "The current drive to make banks less leveraged and safer is having the perverse consequence of destroying money balances," he said. "It strengthens the deflationary forces in the world economy. That increases the risks of a double-dip recession in 2010."

Referring to the debt-purge policy of US Treasury Secretary Andrew Mellon in the early 1930s, he added: "The pressure on banks to de-risk and to de-leverage is the modern version of liquidationism: it is potentially just as dangerous." US banks are cutting lending by around 1pc a month. A similar process is occurring in the eurozone, where private sector credit has been contracting and M3 has been flat for almost a year. Mr Congdon said IMF chief Dominique Strauss-Kahn is wrong to argue that the history of financial crises shows that "speedy recovery" depends on "cleansing banks' balance sheets of toxic assets". "The message of all financial crises is that policy-makers' priority must be to stop the quantity of money falling and, ideally, to get it rising again," he said. He predicted that the Federal Reserve and other central banks will be forced to engage in outright monetisation of government debt by next year, whatever they say now.

The Coming FDIC Bail-out

September 1, 2009
The Wall Street Journal

Americans are about to re-learn that bank deposit insurance isn't free, even as Washington is doing its best to delay the coming bailout. The banking system and the federal fisc would both be better off in the long run if the political class owned up to the reality. We're referring to the federal deposit insurance fund, which has been shrinking faster than reservoirs in the California drought. The Federal Deposit Insurance Corp. reported late last week that the fund that insures some $4.5 trillion in U.S. bank deposits fell to $10.4 billion at the end of June, as the list of failing banks continues to grow. The fund was $45.2 billion a year ago, when regulators told us all was well and there was no need to take precautions to shore up the fund. The FDIC has since had to buttress the fund with a $5.6 billion special levy on top of the regular fees that banks already pay for the federal guarantee. This has further drained bank capital, even as regulators say the banking system desperately needs more capital. Everyone now assumes the FDIC will hit banks with yet another special insurance fee in anticipation of even more bank losses. The feds would rather execute this bizarre dodge of weakening the same banks they claim must get stronger rather than admit that they'll have to tap the taxpayers who are the ultimate deposit insurers. It isn't as if regulators don't understand the problem. Earlier this year they quietly asked Congress to provide up to $500 billion in Treasury loans to repay depositors. The FDIC can draw up to $100 billion merely by asking, while the rest requires Treasury approval. The request was made on the political QT because, amid the uproar over TARP and bonuses, no one in Congress or the Obama Administration wanted to admit they'd need another bailout. But this subterfuge can't last. Eighty-four banks have already failed this year, and many more are headed in that direction. The FDIC said it had 416 banks on its problem list at the end of June, up from 305 only three months earlier. The total assets of banks on the problem list was nearly $300 billion, and more of these assets are turning bad faster than banks can put aside reserves to account for them. The commercial real-estate debacle is still playing out at thousands of banks, even as the overall economy bottoms out and begins to recover. Meantime, even as it "resolves" and then sells failed banks, the FDIC is also guaranteeing the buyers against losses on tens of billions of acquired assets. This is known in the trade as "loss sharing," which is another form of taxpayer guarantee that taxpayers aren't supposed to know about. Most of the losses won't be realized if the economy recovers. But this too is a price of taxpayers guaranteeing deposits. Even as Treasury and the press corps broadcast that the feds are making money on TARP repayments, these guarantees go largely unnoticed. FDIC Chairman Sheila Bair continues to say that deposits will be covered up to the $250,000 per account insurance limit, and of course she's right. But we wish she'd force Congress—and the American public—to face up to the reality of what deposit insurance costs. Amid the panic last year, Congress raised the deposit limit from $100,000. While this may have calmed a few nerves—though the worst runs were on money-market funds, not on banks—it also put taxpayers further on the hook. The $250,000 limit was supposed to expire at the end of 2009, but in May Congress extended it through 2013, and no one who understands politics thinks it will return to $100,000. The rising bank losses mean that the FDIC's ratio of funds to deposits is down to 0.22%, far below its obligation under the insurance statute to keep it between 1.15% and 1.50%. Rather than further soak capital from already weak banks, the FDIC ought to draw down at least $25 billion from its Treasury line of credit. Ms. Bair is going to have to ask for the cash sooner or latter, and she might as well do it before the fund hits zero and we get another round of even mild depositor anxiety. We suppose Congress could raise a faux fuss, but these are the same folks who ordered the FDIC to broaden the insurance limit. They need to face the political consequences of their promises.

Printed in The Wall Street Journal, page A16

Can the souffle rise again?

Ambrose Evans-Pritchard

The Daily Telegraph, August 26, 2009

Ambrose Evans-Pritchard has covered world politics and economics for 25 years, based in Europe, the US, and Latin America. He joined the Telegraph in 1991, serving as Washington correspondent and later Europe correspondent in Brussels. He is now International Business Editor in London.

Two facts that should give pause for thought.

(1) Japanese data released on Thursday showed that exports fell yet again in July. They are down 39.5pc to the US, and 26.5pc to China. Japan is the world’s second biggest economy. It lives on exports. It is also a key part of the supply chain for the Chinese economy. How can this hard data be reconciled with the extreme V-shaped recovery already priced in by the markets?
By the way, Toyota is suspending a key production line at its Takaoka plant in central Japan. It is cutting global capacity by 1m vehicles.

(2) The Baltic Dry Index measuring freight rates for bulk goods and commodities has been falling almost continuously for eleven weeks, dropping from 4,290 to 2,778 on Thursday. Is this just a glut of ships or is this telling us what the Shanghai market is also telling us, that credit tightening by the Chinese government is pulling the rug from underneath the latest commodity bubble?

There is something wrong with the entire recovery tale, which ignores the fact that excess plant is still at the highest level since the Great Depression (capacity use is 70pc in Europe, 68pc in the US, 65pc in Japan, and as low as 50pc in some countries, according to the World Bank’s Justin Lin). Companies will have to cut jobs and investment. Soaring “confidence” indicators have decoupled from reality. The world economy is still prostrate. GDP has shrunk 4pc, 6pc, 8pc, even 12pc or more in a large group of countries. There it more or less sits, like a deflated soufflé. An end to technical recession in France, Germany, and Japan because Q2 ( and undoubtedly Q3 to come) ekes out a rise from a collapsed base does not mean anything – except that zero interest rates worldwide, and a massive fiscal stimulus that is pushing public debts towards 100pc across the OECD states (and cannot easily be repeated once the first sugar rush subsides), has mercifully prevented the Great Contraction from turning into an immediate catastrophe. As the Bank of England’s Governor Mervyn King puts it: “It’s the level, stupid”. The level of economic activity is years away from full recovery. The Bundesbank’s Axel Weber says it will take until 2013 for Germany to get back to where it was. He also warns, by the way, that there will be a second wave of the credit crisis as Germany’s home-grown troubles come to the fore. Round one was imported havoc from the US: round two will be rising defaults at home and a credit squeeze as ratings downgrades force banks to set aside fresh capital. (I enclose the Weber link for German readers http://www.sueddeutsche.de/finanzen/916/484353/text/) I have no idea when stock markets and commodities – especially base metals – will reflect the hard facts on the ground (ie, an end to the Chinese construction bubble). Timing is not my forte. Nor is the market. But I am absolutely convinced that those who think we can return to the status quo ante of the credit bubble as if nothing has happened are delusional. As almost every central banker in Jackson Hole reminded us over the weekend, it is going to be a very long hard slog.

NYT: Banks’ bailouts may convert to equity

White House: Approach will prevent need to seek more cash from Congress

By Edmund L. Andrews
The New York Times
April 20, 2009

WASHINGTON - President Obama’s top economic advisers have determined that they can shore up the nation’s banking system without having to ask Congress for more money any time soon, according to administration officials. In a significant shift, White House and Treasury Department officials now say they can stretch what is left of the $700 billion financial bailout fund further than they had expected a few months ago, simply by converting the government’s existing loans to the nation’s 19 biggest banks into common stock. Converting those loans to common shares would turn the federal aid into available capital for a bank — and give the government a large ownership stake in return. While the option appears to be a quick and easy way to avoid a confrontation with Congressional leaders wary of putting more money into the banks, some critics would consider it a back door to nationalization, since the government could become the largest shareholder in several banks. The Treasury has already negotiated this kind of conversion with Citigroup and has said it would consider doing the same with other banks, as needed. But now the administration seems convinced that this maneuver can be used to make up for any shortfall in capital that the big banks confront in the near term.

More risk to taxpayers

Each conversion of this type would force the administration to decide how to handle its considerable voting rights on a bank’s board. Taxpayers would also be taking on more risk, because there is no way to know what the common shares might be worth when it comes time for the government to sell them. Treasury officials estimate that they will have about $135 billion left after they follow through on all the loans that have already been announced. But the nation’s banks are believed to need far more than that to maintain enough capital to absorb all their losses from soured mortgages and other loan defaults. In his budget proposal for next year, Mr. Obama included $250 billion in additional spending to prop up the financial system. Because of the way the government accounts for such spending, the budget actually indicated that Mr. Obama might ask Congress for as much as $750 billion. The most immediate expense will come in the next several weeks, when federal bank regulators complete “stress tests” on the nation’s 19 biggest banks. The tests are expected to show that at least several major institutions, probably including Bank of America, need to increase their capital cushions by billions of dollars each. The change to common stock would not require the government to contribute any additional cash, but it could increase the capital of big banks by more than $100 billion.

The White House chief of staff, Rahm Emanuel, alluded to the strategy on Sunday in an interview on the ABC program “This Week.” Mr. Emanuel asserted that the government had enough money to shore up the 19 banks without asking for more. “We believe we have those resources available in the government as the final backstop to make sure that the 19 are financially viable and effective,” Mr. Emanuel said. “If they need capital, we have that capacity.” If that calculation is correct, Mr. Obama would gain important political maneuvering room because Democratic leaders in Congress have warned that they cannot possibly muster enough votes any time soon in support of spending more money to bail out some of the same financial institutions whose aggressive lending precipitated the financial crisis. The administration said in January that it would alter its arrangement with Citigroup by converting up to $25 billion of preferred stock, which is like a loan, to common stock, which represents equity. After the conversion, the Treasury would end up with about 36 percent of Citigroup’s common shares, which come with full voting rights. That would make the government Citigroup’s biggest shareholder, effectively nudging the government one step closer to nationalizing a major bank.

Nationalization, or even just the hint of nationalization, is a politically explosive step that White House and Treasury officials have fought hard to avoid. Administration officials acknowledged that they might still have to ask Congress for extra money. Beyond the 19 big banks, which are defined as those with more than $100 billion in assets, the Treasury has also injected capital into hundreds of regional and community banks and may need to provide more money before the financial crisis is over. Treasury officials say they have more money left in the rescue fund than might be apparent. Officials estimate that the fund will have about $134.5 billion left after the Treasury completes its $100 billion plan to buy toxic assets from banks and after it uses $50 billion to help homeowners avoid foreclosure. In practice, the toxic-asset programs are not expected to start for another few months, and it could be more than a year before the Treasury uses up the entire $100 billion. Likewise, it will be at least a year before the Treasury uses up all the money budgeted for homeowners. But the biggest way to stretch funds could be to convert preferred shares to common stock, a strategy that the government seems prepared to use on a case-by-case basis. Ever since the Treasury agreed to restructure Citigroup’s loans, officials have made it clear that other banks could follow suit and convert their government loans to voting shares of common stock as well.

Setting yardsticks

In the stress tests now under way, regulators are examining whether the big banks would have enough capital to withstand an economic downturn in which unemployment climbs to 10 percent and housing prices fall much further than they already have. As their yardstick, regulators are expected to examine a measure of bank capital called “tangible common equity.” By that measure of capital, every dollar a bank converts from preferred to common shares becomes an additional dollar of capital. The 19 big banks have received more than $140 billion from the Treasury’s financial rescue fund, and all of that has been in exchange for nonvoting preferred shares that pay an annual interest rate of about 5 percent. If all the banks that are found to have a capital shortfall fill that gap by converting their shares, rather than by obtaining more cash, the Treasury could stretch its dwindling rescue fund by more than $100 billion. 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. Those are exactly the kinds of conflicts that Treasury and Fed officials were trying to avoid when they first began injecting capital into banks last fall.

Copyright © 2009 The New York Times