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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis.

 
 
Oct 20

Written by: Jack Ciesielski
10/20/2008 7:47 AM 

Take a Chevy Tahoe, add bling, call it a Cadillac Escalade - and GM improves its survival odds if it sells more Escalades than Tahoes.

It's a trick we've all seen for years: take your basic model, extend it a bit here and there, make options standard and presto! You've got a more exciting version of the same thing that you can sell for a better price. It's not always a winning strategy: Chrysler had an amusing turn with its "Plodges." And for crying out loud, Taco Bell has been using it for years. A Chalupa is a Gordita is a Crunchwrap.

Which is the point: you can put a different wrapper around the same product, but underneath, a Caddy Escalade is a Chevy Tahoe. You can put a Dodge front end on a Plymouth, but a "Plodge" was still a Plymouth and nothing more. And the stuff inside a Chalupa, Gordita or Crunchwrap is indistinguishable from one iteration to the other. (Or just plain indistinguishable.) It's the wrapper that provides the delivery system for what's inside.

Which brings us to the Treasury Department's "Troubled Asset Relief Program." As the Treasury prepares to inject a $250 billion vitamin shot into 10 large banks, investors should ask themselves about how such an investment will appear on the balance sheets of the investees.

Take a look at the term sheet for the injection. The government plans to buy preferred stock, now in vogue. It'll carry a 5% dividend, rising to 9% after five years; it can't be redeemed for at least 3 years; restricts dividends on junior preferred stock or common stock; has no voting rights; and restricts executive compensation to be in accordance with the Emergency Economic Stability Act's requirements.

One other thing: it has a "perpetual life," apparently because the term sheet says so. Realistically, the Treasury is not going to be a longer-term player in these preferreds any longer than it has to be - and there are no restrictions on the transferability of its investment.

Sounds a lot like debt? That's because it is. This is the Treasury's version of a "Plodge" - it's debt with an equity skin around it. Under that equity wrapper, it's still debt. For regulatory purposes, it's considered Tier 1 capital. That's just fine - if the regulators want to consider it to be part of the lending capital base, that's their playground. They can change those capital requirements as they see fit - it's part of the joy of being the regulator.

When it comes to financial reporting to public investors, it would be more realistic to see it classified as a liability. Think of it: how much risk is there to Treasury compared to common equity holders? None - the Treasury is playing the role of a lender, with all the protections a lender requires.

Render unto Caesar what is Caesar's. And report to shareholders what is the shareholders'. The FASB has had a liabilities and equity project simmering for years, and the most recent conclusion they reached was that the only thing that should be considered equity is - common equity. Tomorrow they will be discussing the project once more, and probably will twist themselves into knots trying to come up with some kind of rationale for stuffing this preferred issue into the equity category. Let's hope they stick to Plan A - but don't get your hopes too high.

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