US Government Converting TARP Loans Into Common Stock: What It Will Mean For Investors

On Monday the US Government started to talk about the possibility of converting TARP loans, made to financial institutions, to common equity. This is a major change in the original program. The NY Times highlighted a interesting story on the process. Essentially, the government is going to convert their loans to common, thereby increasing the amount of common shares outstanding. This will mean that any earnings that the banks have will now be spread across more common shares. This is a step closer to nationalization.

What will this mean to investors?

Here’s my thoughts.

• Current equity holders face further dilution - negative for equity holders.
• Bond Holders: Positive impact as preferred conversion improves cash flow for existing bondholders.
• Taxpayers: Negative impact. Now they will own common and not be receiving interest.

This is a short term fix. Essentially the government is buying stock in the banks because nobody else will. The government is becoming the buyer of last resort here. What has changed since last fall is that buyers of common equity of the financials have essentially disappeared - with the exception of the government. The unemployment rate continues to move higher as consumers struggle further to pay their credit card bills. Consumer spending is evaporating. General Growth Properties, one of the largest operators of malls in the country has declared bankruptcy.

This is not a positive sign.

I still like Direxion Financial Bear 3X Shares ETF (FAZ). I believe that the selling trigger for FAZ will be one of two events taking place.

1. Private money is willing to buy common equity of the financials.
2. Bond holders are forced to restructure their bond holdings in return for “new” shares.

I would consider a buy and hold of FAZ until either one of these two events becomes evident.

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