The Banks - Something Doesn't Add Up

There was quite a bit of banking news today, largely spurred by this NY Times article discussing the government's plan to convert their preferred shares from TARP to common shares as a method of recapitalizing the banks.  

Krugman, Cowan, Kwak and others have argued that this is "just an accounting gimmick" akin to "arranging the chairs on the deck of Titanic".  I'm always suspect, of any Krugman criticism of the Obama administration since he hasn't had a good thing to say about it yet (it started with this spat during the primary).  That isn't to say he hasn't been right about some things.

However, this is a situation where he and the others mentioned are a little off base.  The preferred shares that the government currently owns are very similar to debt, obviously you wouldn't further increase the liquidity in the credit markets by saddling a bank with more debt (it's another question on why this was done initially).  University of Louisiana at Lafayette professor Linus Wilson makes the point :

Even if no new money goes into banks, common stock creates different incentives than preferred.  Managers, if they are doing their job, maximize the value of common stock (not preferred stock).  Limited liability means that a distressed bank will have perverse incentives until it has enough common stock to absorb those losses.  With too little common equity, banks will pass up good loans because too many of the gains are realized by preferred stockholders and debt holders.  Managers running banks with too little common equity will be tempted to make speculative loans and shift those losses onto senior creditors (preferred stockholders and bondholders).  

Maybe that explains why the banks haven't been lending:

Note: as you can see above, some banks like Wells Fargo actually have been lending

But if they haven't been lending?  Why are they rushing to give back the TARP money, which they clearly need to be comfortable lending again?  It has to be the executive compensation limits, but if that is the case then that is a very bad sign for the future of the "public-private" partnership.  Hopefully Geithner stands his ground and doesn't allow the return of the TARP money until the banks show they are willing to lend.