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Is The Capital Assistance Program Structured Backwards?

James Kwak has an excellent post up on The Baseline Scenario about the government’s Capital Assistance Program. His contention is that Treasury structured its convertible preferred stock investment backwards.

To summarize his position, he argues that the government gave the banks the right to put common shares to the government by forcing conversion of the convertible preferreds that the government plans to buy. The proper structure in his view would have been for the government to have a call option, specifically the right to convert at the government’s option. My explanation is an oversimplification so I urge you to read his entire post.

There is no argument with Mr. Kwak’s position if you view the transaction as a private party deal. He cites the venture capital industry as an example. There the use of convertible preferred is common and the investors usually have the right to convert their preferred at their option. That naturally makes sense as any investor is by definition the control party and wants to maintain that position for an indeterminate period of time.

I’ll go out of my league here and suggest that his thesis doesn’t adequately address the nature of this particular set of circumstances.

While he is absolutely correct in stating that the structure presents some opportunities for abuse on the part of the banks, he ignores the fact that there is a different relationship between the investor and company than exists in the private sphere. The investor in this case has the ultimate power to dictate whatever terms it chooses on the company in which it invests. Any attempt to game the system could be unilaterally vetoed by the government since it controls the ability of the company to continue to operate. Basically, banks exist at the sufferance of the government.

Ultimately the goal of the government’s preferred stock investment is not to make a profit but rather to sustain the banks. Presumably the stability provided by the investment allows them to grow their way out of their current predicament and repay the government. With luck, along the way they will begin to demonstrate commercial viability and attract private capital which, as I understand the program, must be used to reduce the government’s investment. Private investors are unlikely to come if the government holds a call. I suppose you could argue that the terms could be rewritten at the point in time that occurs but what would be the point. Not ever converting the preferred due to favorable outcomes is the desired result. Why erect any impediments to that goal.

The investments contemplated under the plan are to be made from a public policy perspective not from an entrepreneurial one. Viewed in that manner it’s hard to argue that the structure is that flawed or flawed at all.

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