Rescue Plan Relies on Accounting Finesse
Treasury’s latest plan to address the credit crisis by direct investment of $250 billion in US banks has politicians telling Americans one thing and firms telling investors another. Politicians tell Americans the investments are temporary, no threat to private market capitalism in a democracy; thanks to deals brokered by Treasury and the Securities and Exchange Commission this weekend, firms will tell investors the investments are permanent, necessary to account for them as increasing firms’ permanent capital and minimizing dilution of common stockholders.
The tension is finessed by imaginative design and classification of the two components of the government’s investment: preferred stock and warrants to buy common stock. As to the preferred stock, the solution is designing terms to exploit a gray area in accounting dividing debt from equity. Borrowed funds a firm must repay are debt (liability); permanent funds a firm need not repay are equity (capital). Preferred stock is a liability if the firm must repay it and equity otherwise.
Critical to the Treasury’s plan is boosting firms’ equity capital, which means making the securities look as permanent as possible. But if they look too permanent, that would impeach the political story. The result is a term sheet negotiated this weekend calling the preferred perpetual while incentivizing firms to repay it within five years, without an explicit obligation to do so. Examples include a spike in the dividend rate at year five from 5% to 9%, forbidding firms to pay dividends on common stock unless dividends are first paid on preferred and limiting firms’ right to repurchase common stock while the preferred is outstanding.
The warrants pose an additional problem as wsj.online reports. To treat them as permanent equity capital, ordinarily a firm must prepare financial statements as if the warrants had been converted into common stock. But doing so would increase reported common shares outstanding, diluting earnings per share and book value per share. To avoid that, Treasury seems to have gotten the SEC to say it would not object to treating warrants as equity capital now so long as the bank has, or within one quarter obtains, shareholder authority to issue the required number of new common shares.
Must finessing accounting standards play so central a role in Treasury’s plan and balancing political need to sell deals as temporary with regulatory need to say banks have enough permanent capital? If Treasury thinks government’s investments give banks adequate permanent capital, why not simply modify existing capital adequacy rules to support this conclusion instead of manipulating design and classification to get desired accounting treatment?
Finessing accounting treatments tend to exacerbate problems, not cure them. This lesson is frequently re-taught. Examples include 1980s US thrift crisis, 1990s Japanese banking crisis, Enron’s early 2000s fraud, and even this 2008 credit crisis Treasury is trying to fix.
Hat tip: Lynn Turner, Former SEC Chief Accountant