What Will Happen to Banks that Fail the Stress Test, When You and I Own Wall Street

The outcome of the “stress tests” will be that the banks needing extra capital will get it from the Treasury. But where will the money come from, now that the TARP fund is almost exhausted and Congress is dead set against providing more bank bailout money? The Treasury will simply swap debt for equity – turning what the banks owe the government into shares of stock in the banks. Presto. Ailing banks will get more capital, and Tim Geithner won’t have to go back to Congress to ask for it.

But by this sleight-of-hand, the public takes on more risk. Much of the money we originally gave Wall Street took the form of senior debt. We were preferred creditors, meaning that in the event of bankruptcy (or some form of it) we’d get repaid first. But as shareholders, we’d get nothing. As we’ve seen time and again during this economic crisis, shareholders lose big.

It’s possible, of course, that this is the perfect time to get shares in major Wall Street banks, because the economy is poised for recovery. But it’s just as possible this is the worst time – especially in banks judged by the Treasury to be inadequately capitalized – because nonperforming loans keep mounting. They won’t be repaid because so many people continue to lose their jobs, even though the pace of job losses may be slowing. And because they’re losing their jobs, they can’t pay their mortgages or credit card balances, or even shop at stores that are closing on Main Street, thereby threatening commercial real estate as well.

There’s a second problem with the debt-for-equity swaps. We the public become controlling shareholders in several large Wall Street banks. Should we be active shareholders – using our clout to get management to do things management might not otherwise do? Or passive shareholders, relying on the remaining private shareholders to police management? I’d say we should be active. But that only raises a whole host of questions. First, who represents us?

More importantly, if we’re active shareholders, is our main objective to make sure the banks become profitable and our we get repaid? Or should we push management to take actions that are in the public interest but not necessarily geared toward higher shareholder returns in the foreseeable future – such as limiting executive compensation, limiting the payout of dividends, and pushing the banks to make more loans to Main Street? I’d say we should do the latter. Otherwise, why bother bailing out the banks to begin with?

• Become A Funded Futures Trader