Baker on rate conversion

The Stress Free Stress Tests

The NYT discussed the possibility that the Obama administration may seek to shore up the core capital of the major banks by converting its preferred shares that it purchased last fall into equity shares. The article does not discuss the very important issue of the rate of conversion.

At the time the government converted its preferred shares in Citigroup to common shares, the conversion ratio was far below the market value. By accepting a ratio below the market value, the government was essentially just giving money to Citigroup and its shareholders. It will be important to examine the price for any future conversions to determine if they are also government giveaways to the banks.

The article also refers to the stress tests that the government is imposing on the banks. The negative scenario in these tests is that the unemployment rate rises to 10 percent. At this point, it is virtually certain that the unemployment rate will rise above 10 percent by the end of 2009 and will likely still above 10 percent for most or all of 2010. This means that the economy is likely to impose far more stress on the banks that is assumed in these tests.

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