Apparently the Treasury plans to introduce a new type of security to help banks that failed, oops, I mean didn’t get high enough grades on the stress test top off their capital. If they can’t get the capital they need from the private sector they can exchange their existing TARP preferred stock for mandatory convertible preferred stock.

What’s that you ask. Well let me let the WSJ describe it for you:

Banks that are found by government stress tests to need additional capital will have two choices: raise the money from the private sector, or go back to the government trough. But instead of taking more money, the government expects many banks to exchange the Treasury Department’s existing preferred stakes — which it acquired last year at the height of the financial crisis — for a new type of preferred share.

This new instrument, called a “mandatory convertible preferred” share, gives banks the ability to create common equity as needed. The preferred shares convert to common shares when a bank or its regulator decides they should, or within seven years. Regulators are paying more attention to the common equity each bank holds, in part because it measures what shareholders would have left if a company were liquidated.

By keeping the investments as preferred stakes, the government remains a passive investor, helping it defer the tricky question about how active a shareholder it would be. The government only gets voting rights once the shares are converted into common equity. Most importantly, this preferred convertible stock counts towards building the buffers that are required by the Fed to protect against future losses, and that are known as tangible common equity, or TCE.

Banks may want to convert their existing stakes into new “mandatory convertible preferred” shares so they can avoid taking additional government money. While the conversion won’t give the company more cash, it would satisfy regulators’ concerns about the quality of capital at the banks.

I’d boil this down by saying that the government redefined TCE to include preferred stock owned by the government that has a couple bells and whistles attached to it. In a simpler time they simply said they were going to engage in forbearance and resolve the bank if and when it became necessary. Now to reach the same end, we seem obliged to borrow vast sums of money to inject into banks in the form of supposedly novel securities in order to pronounce them well capitalized. Such is progress.

It will be passingly interesting to see the details of Geithner’s Preferred. Things like coupon, conversion details, whether or not the government gets even more warrants if the banks exchange for it, you know, the little things. On the bigger side, how can a regulator decide it wants to convert? Are there going to be real rules or will it be like TARP repayment — the government gets to make up the rules as it goes along. 

And will an investor want any part of common stock in a bank that has this hanging over their head? If a bank opts to go this route does that semi-permanently make it a ward of the state? Seems like a swamp that might be hard to get out of once you put yourself in the middle of it.

Of course this plays out well for the Obama administration. I don’t think for a second that they wanted this problem but they have it and don’t seem shy about using the clout that comes with “saving the financial system.” Hey, lemonade from lemons! With the Geithner Preferred they can continue to deny government control of the banks while exercising control when it’s convenient to do so. 

Now if you really can’t get enough of this, Geithner is on Charlie Rose tonight. You can follow the link over there and wallow in all of this. As for me, I hereby promise not to do another post about the stress test unless something really juicy arises.