The government is planning to convert the loans it gave to troubled financial institutions to common stock. This would transform the government's position from a lender to a majority owner of some of the world's biggest banks.
The downside of this deal is that the government will take on more risk when it converts the original preferred shares to common equity. The government can only retrieve taxpayer money if stock prices go up. Also, preferred shares have a superior claim to a firm's assets if it files for bankruptcy. With common shares, you're much further down in the pecking order.
Converting preferred shares to common ones isn't a new concept. The U.S. Treasury has already converted preferred shares in Citigroup to common shares, and now has a 36 percent stake in the banking giant.Citigroup's shares have since risen more than 40 percent in the past six weeks.
So far the government has given $140 billion to the 19 largest financial institutions. These loans have come in the form of preferred stock, without voting rights, and pay about a 5 percent interest rate. The banks, meanwhile, haven't done much to boost their popularity in Congress. Some politicians are angry about the banks' delay at lending the money to the public and bonus payments to executives. Since Congress is sounding unlikely to increase the amount of bailout money, the Obama administration sees converting the original loans into common shares as a way to make more capital available for these banks.
This move could suggest that the government is confident the banks will be stronger in the future and the share price will be higher when it decides to sell. Not everyone is as optimistic as the government. There have been some concerns that the rally for financial stocks is over-extended. Calls for "too big to fail" organizations to be broken up could change the financial landscape dramatically, with banking behemoths taking a back seat.