The plan to inject capital into US banks and brokers has hit a snag (via WSJ):
Under the plan, banks are required to issue so-called warrants, which give the government the right to purchase a bank’s common stock at a certain price. Since the government may eventually convert those warrants into stock, banks have to at some point register stock to cover the warrants.
The banks worry they will be penalized either if they issue new stock immediately or whether they wait.
If the banks register shares immediately, such a move could hurt their earnings per share and their “book value per share” because it would increase their number of shares outstanding. Book value is an important measure for banks because it essentially reflects a bank’s net worth.
But if banks don’t register the stock now, they will trigger an accounting rule that forces them to treat the warrants as a liability. That means the banks could potentially be forced record a loss if their stock price increases. This condition stems from the legislative language that gave Treasury authority to buy the stakes as part of a $700 billion bailout package.
Under the plan, Treasury has the right to buy common stock equal to 15% of its total investment in a firm. The Treasury will get the right to buy shares at the price a firm’s stock is trading at on the day Treasury makes its investment. If the stock is trading at, say, $10 per share on the day of the investment and increases to $20, Treasury can make a profit.
If the warrants are treated as a liability, that liability could increase if the value of the warrants climbs. When a liability increases in value on a company’s books, it has to take that increase as a charge against profit. This would then result in lower retained earnings, which could lessen a bank’s net worth and therefore its capital.
There is no way to deny the reality of this situation. The warrants are future liabilities; how they are recorded is irrelevant. Any way you slice it, current shareholders will be diluted unless the bank fails, which of course is the ultimate dilution.