TCE and How to Eat It

On Tuesday morning news were buzzing with excitement over non-nationalization of Citigroup. The word "nationalization" permeated the markets last week when Alan Greenspan himself, ardent proponent of free markets, mentioned that not only tighter regulation but also nationalization of some larger financial institutions may be necessary. His words were echoed by Sen. Lindsey Graham (R). Markets did not like such prospective, and a massive selloff ensued, bringing Citigroup shares to a 17-year low and Dow to a 6-year low on February 19.

The gloom was partially alleviated last night as U.S. government released new plan of converting its $45B preferred stock holding into common shares, and affirmed that financial industry will remain in private hands. Markets in Europe, Asia and Americas rose on such statements and U.S. Treasurys dropped.

Such contradiction would be abnormal in earlier periods but this is abnormal times. Markets are most afraid of overdue regulation and especially outright nationalization of financial institutions. Once scare with the worst, they seem to cheer the lesser evil: U.S. buy into Citi which of course dilutes equity but does not eliminate it completely.

Why was there a need to convert preferred shares (which give U.S. taxpayer a somewhat protected position) into much riskier common stock?

This conversion is aimed at improving a previously obscure TCE ratio - Tangible Common Equity. TCE = common stock + add paid-in capital - deferred compensation + accumulated comprehensive income.

So is it an artificial way to show better capitalization or is it a way to appropriately demonstrate all equity stakes? What does this conversion mean to U.S. taxpayer? Are we taking a riskier position for the sake of accounting games?

I have seen 2 reasons cited:

1) Recent drop of Citigroup shares to dangerous lows can cause trouble if customers start withdrawing their deposits. So I am wondering - why does U.S. government think that change of labels can stop people who have already lost a lot of their assets and may want to protect what's left. If this conversion is supposed to give us confidence in Citi backing by U.S. Government, then isn't it equivalent in spirit if not in form to nationalization?

2) This week Fed starts testing bank's capitalization levels with emphasis on TCE ratio rather than traditional Tier 1. In addition to common stock Tier 1 capital measures equity other than common stock and includes stock options, accounting reserve and deferred compensation such as deferred tax credit (which we know all banks now have a LOT). So effectively, the conversion boosts the TCE ratio so that Citi can pass the test but then again, at the cost of a riskier position for U.S. taxpayers.