The latest alterations Citigroup ( C) is reportedly seeking to its federal bailout may be aimed largely at an accounting measure that investors paid scant attention to until recently: tangible common equity. Citi, according to published reports this week, is negotiating to convert some or all of the government's $45 billion preferred equity stake into common shares. The stock rallied, even though such a move would not give the bank any new capital and would dilute current common shareholders. Converting the government's preferred stake into common stock would eliminate the 5% dividend Citi pays on the preferred shares, thus saving $563 million per quarter. But another significant advantage of the conversion is completely cosmetic. The new common shares would be counted as tangible common equity, which measures common shareholder's equity capital less goodwill (the accumulated premiums a company has paid for acquisitions) and other intangible assets. Troubled insurer AIG ( AIG) reportedly is considering a similar move. In an environment of uncertainty, tangible common equity gives the common stockholders an idea of what their stake is actually worth. It provides the most conservative estimate of the value of the common shareholders' stake in the company. With the government a major investor in many of the larger banks, the Federal Reserve is expected to emphasize tangible common equity in the " stress tests" it intends to use to determine which financial institutions are worthy of government aid going forward. But there are other, more traditional ways to gauge capital adequacy.
Bank regulators have in the past relied on the tier-1 leverage ratio, with tier-1 capital excluding goodwill and some other intangible assets and some non-qualifying preferred shares from total equity capital, to come up with a more conservative measurement of a bank's solvency. In order to be considered well capitalized, a bank needs to maintain a tier-1 leverage ratio of at least 5% and a total risk-based capital ratio (which takes loan loss reserves and asset risk into account) of at least 10%. There are always three sets of numbers to look at for the largest banks. The banks themselves file call reports. The holding companies make quarterly and annual filings with the Securities and Exchange Commission, and bank holding companies also file a uniform consolidated financial statement with the Federal Reserve. The following list includes tangible common equity ratios, as provided by Barclays Capital, along with tier-1 leverage and total risk-based capital ratios from the Dec. 31 uniform holding company financial statements filed with the Fed:
So, where should investors look? If they are considering the solvency of an individual bank or savings and loan (not a holding company) the capital ratios on bank call reports and thrift financial reports are the best indicator of solvency, as recently discussed in TheStreet.com's analysis of undercapitalized thrifts, which included our most recent list of undercapitalized banks. If they are considering the solvency of a large bank holding company, capital ratios are provided on the uniform regulatory consolidated financial statements, although holding companies are not required to maintain specific capital ratios to be considered well-capitalized, the way banks are. These ratios will be considerably higher than the tangible common equity ratios listed below, since most preferred shares are included.
One quick thing to point out is that, since the tier-1 leverage ratio uses a bank's average total assets in the denominator, the ratio for Wells Fargo ( WFC) was artificially high. The company's total assets more than doubled in the fourth quarter, with the acquisition of Wachovia. Wells Fargo's total risk-based capital ratio was the lowest on the list. Otherwise, the tier-1 leverage and total risk-based capital ratios greatly exceed the tangible common equity ratios, because most preferred shares are included. In its Large-Cap Banks report released Monday, Barclays Capital analyst Jason Goldberg listed Bank of America's ( BAC) tangible common equity ratio at 2.6%, with ratios of 2.8% for Wells Fargo, 3.9% for JP Morgan Chase ( JPM) and just 1.5% for Citigroup, which was by far the lowest for any of the 21 large holding listed in the report. Dr. David Ely, Professor of Finance at San Diego State University, said coming losses for the large banks are "the biggest unknown, and far more important than trying to reconcile tangible equity ratios." Ely also said that the stress tests might be a better way for the Treasury to allocate assistance to banks going forward. Federal bank regulators on Monday said they would begin new Capital Assistance Program would begin Wednesday, through which large institutions will be evaluated through the stress tests. Companies in need of additional capital will "have an opportunity to turn first to private sources of capital," before the government increases its preferred stakes to "cushion against larger than expected future losses." Investors will have quite a bit to gnaw on when results of regulators' stress tests of the large banks are known. In addition to concerns about their stakes being further diluted, there may be more surprises in store as BofA, Wells Fargo and JPMorgan Chase continue to work through their huge acquisitions.