Massive Bank Shareholder Dilution Ahead

It was the bank reports of good earnings (albeit much of a one-time nature and based on yield spreads that cannot go on forever) that started and continued to fuel this rally. But how valuable are questionable improvements in earnings at the same time that shareholder dilution is around the corner, as this article would lead one to imagine:

April 20, 2009 (Reuters) Obama administration officials have determined they can avoid asking Congress for more bank bailout funds by converting existing loans to the largest U.S. banks into common stock, The New York Times reported on Sunday.

… Converting the loans to the 19 biggest U.S. banks into common shares would turn the government aid into available capital and give the government a large equity stake in return, the newspaper said.

Some critics would consider the option a back door to nationalization since the government could become the largest shareholder in several banks, the report said.

We’ve been saying for several months that we are in a government policy driven market, and an environment of high uncertainty with sudden and arbitrary rules changes — hardly the conditions for the faint of heart or financially conservative to be engaged in risk taking.

Can the rally sustain itself with backdoor quasi-nationalization of major banks materializing before our eyes? Can bank profits generated by one-time accounting rule changes, massive injections of free taxpayer money and an amazing yield curve be seen as something reassuring about the financial system? We don’t think it can rationally, but since when does rationality govern markets in the short-term. Long-term, yes — short-term, no.

With money market fund managers having to lose money or pay negative yields to fund shareholders, we’d bet on negative yields. While some investors may bite their lips and endure near zero money market yields, we suspect that human emotions will react strongly, maybe violently, to negative yields and cause money to move to riskier assets (maybe bonds, but also stocks) to avoid the unthinkable — paying rent to the money fund to warehouse cash. Switzerland got away with it, but it won’t work here, unless we have demonstrated deflation which would make the nominal negative rates become positive real rates.

Yes, we believe risk averse people could actually move to higher risk out of shock and anger at negative money market yields. With a 4 basis point 1-month Treasury and 20 to 40 basis point management fees, how long can even 1 basis point money market yields be maintained?

US Treasury Yield Curve:

click image to enlarge

Rationally, going from 1+% to near zero should have been more emotionally charged than going from near zero on the positive side to near zero on the negative side, but emotion rules the crowd. We don’t think the crowd will go for negative yields.

Will the investors, move out the yield curve to longer maturities to restore yield? Will they move down the quality scale to restore yield? Will they buy stocks to get away from negative money fund yields? Will they stay where they are and take the yield hit in the belief the rally will fizzle as GM and Chrysler prepare for bankruptcy and the US government prepares to convert debt to equity at major banks creating massive bank shareholder dilution?

Which emotional and rational push and pull will prevail in the next days and weeks?

Can the likes of Bank of America (BAC) and Citigroup (C) continue to skyrocket with the US government diluting the private investors by converting TARP loans to common stock?

Disclosure: No positions in stocks named in article

Comments

[Teutonic Kn...:]

Wasn't this obvious? Just look at what happend to Royal Bank of Scotland...

Apr 20 12:50 PM

[SW Richmond:]

Mr Shaw,

Proposed, never implemented. Wired Magazine - Cash and the Carry Tax.

www.wired.com/politics...

Apr 20 02:01 PM

[SW Richmond:]

There's this too:

www.nytimes.com/2009/0...

"Economic View

It May Be Time for the Fed to Go Negative
By N. GREGORY MANKIW
Published: April 18, 2009"

Apr 20 02:43 PM

[Richard Shaw:]

SW Richmond -- this is very scary stuff. Both of your references, the one from a Fed Reserve SVP in 1999, and the one from a Harvard professor in the NYT this weekend are shocking. The idea that markets could generate negative interest rates is one thing, but a government tax on currency that is held and not spent or deposited in a government sanctioned institution is from a world I never hope to live in. Thanks for pointing out these two sources.

Apr 20 02:55 PM

[doubleguns:]

Convert cash to gold avoid the tax. Or keep your cash in a safety deposit box. Problems with large amounts of cash however. Send it off shore to an off shore bank.

I can see all kinds of problems here if a tax on cash happens. How much capital would leave the country?

Apr 20 03:16 PM

[SW Richmond:]

Mr. Shaw,

I'm glad the information is of use to you. It is extremely scary stuff, made even scarier by the matter-of-fact manner in which it is proposed by adherents. This willingness to do anything imaginable and many things unimaginable is why I have been, and remain, firmly in the inflation / currency destruction camp.

Apr 20 03:35 PM

[User 353732:]

Once upon a time in America, the Government used taxpayer money to fight organized crime and used tax evasion to send notorious criminals to prison. Today, it seems, the Government uses taxpayer money to finance organized crime and promotes tax evaders to high public office.

Apr 20 03:40 PM

[ERCaptain:]

And WFC, and BAC, and regional banks... this is how socialism starts under our very noses.
The government knows best? They are telling banks that they will not allow them to re-pay if it is not in the "best interest" of the American people or the American economy?!?! Are we going to say this to banks that did not want the "gov loans" to begin with?
To me this is truly scary territory. Since when does the government know best (outside of prudent regulation to curb the basic problem of theft, etc.)
Many banks would like to be free from the gov imposed rules - but we are happily giving up free markets in exchange for a "our big brother knows best".
Wierd, I have never been a conspiracy person or an alarmist. But very quickly I am beginning to worry that I may not even have the freedom to write this. I could be in trouble with the government because what I am thinking and writing here may not be in the best interest of the American people or the economy?

Apr 20 04:23 PM

[MIKETRADER:]

last week I comented.....

"The perpetual & non.cum preferreds, are discounting a forced conversion into common equity, which may or not happen, from what I been reading from bank analyst they see a range from 10% the more optimistic to 40% the more pessimistic dilution on common equity at BAC, IMO I think the dilution will come north of 10% which maybe is done through a stock offering and not a conversion (given what has happened recently with HSBC).

By the way I see more dilution if it were to come on a TCE/RWA @ 3% for WFC that for BAC, I see a 20% dilution, but will see......"


Having said that, with the news of today, I think the "nationalization" agenda will take momentum again, and my previous dilution rates may be too optimistic.... the best trade you can do is:

* short the commons on BAC & WFC and buy their perpetual non-cum preferrds, if this forced conversion take place youre going to make a lot of money.... just be carefull short the commons via options so you dont get short squizzed!

Apr 20 05:11 PM

[Stone Fox C...:]

These high yield spreads definitely won't go on forever, but why won't they remain in place until the banks are out of danger? As the banks become stronger, the yields will lower so naturally banks might struggle to grow profits, but why would that diminish until the credit losses start slacking? With that being the case, how could any of these banks fail the stress test. They've all got huge operating incomes coming in to offset credit losses. We really think the gov't is gonna take that away so that banks will fail?? Why would they have done so much work to prevent it to just take it away at the point the corner is being turned? Argue long term valuation all you want, but insolvency seems very hollow as a thought process now.

Apr 20 05:13 PM

[BxCapricorn:]

How could the treasury not receive the results? Their 20 auditors performed the test, and the test was completed. That's a very strange response.


On Apr 20 10:40 AM Richard Shaw wrote:

> mac123449 -- here is copy from a Reuters article a few minutes ago
> concerning the Turner Radio Network blog you cite, and the US Treasury
> response:
>
> WASHINGTON (Reuters) - The Treasury Department has not yet received
> the results of "stress tests" on the health of the nation's 19 top
> banks, spokesman Andrew Williams said on Monday, after a blog said
> it had obtained the test results and some U.S. bank shares moved
> lower.
>
> Williams made the comments after banks added to losses before the
> market open following a "free speech" blog, called the Turner Radio
> Network, said 16 of the 19 are "technically insolvent." The post
> cited what it said was a U.S. government report.
>
> "There is no basis for that report, we do not even have results yet,"
> Williams said.

Apr 20 05:16 PM

[BxCapricorn:]

Very interesting article, that could only be penned by an academic. Can you imagine telling some out of work industrial worker that his paper money is no good because of a serial number, when he tries to buy beer at the 7/11, and that it needs to be confiscated?

Hello. Reality calling. You'd give the alternative barter economy a gigantic boost, while unifying every race, creed and color against the banking system. These type of "games" in order to "rig" an insolvent banking system, must stop.

I've read Mankiw's blog for years, and he's so insulated in "academia" that his posts often leave me shaking my head in disbelief. He's not as bad as Mark Perry, of the Carpe Diem blog though....and I'm out of quotation marks, so I'll leave it at that.

On Apr 20 02:43 PM SW Richmond wrote:

> There's this too:
>
> www.nytimes.com/2009/0...
>
>
> "Economic View
>
> It May Be Time for the Fed to Go Negative
> By N. GREGORY MANKIW
> Published: April 18, 2009"

Apr 20 05:24 PM

[SW Richmond:]

More:

delong.typepad.com/sdj...

"Silvio Gesell and Stamped Money: Another Thing Fisher and Wicksell Knew that Modern Economists Have Forgotten"

The article includes an extended quote about Gesell written by my favorite person from all of history (gag), Keynes:

"[H]e had carried his theory far enough to lead him to a practical recommendation, which may carry with it the essence of what is needed... the prime necessity is to reduce the money-rate of interest, and this, he pointed out, can be effected by causing money to incur carrying-costs just like other stocks of barren goods. This led him to the famous prescription of 'stamped' money, with which his name is chiefly associated and which has received the blessing of Professor Irving Fisher.... [C]urrency...would only retain their value by being stamped each month, like an insurance card, with stamps purchased at a post office. The cost of the stamps... should be roughly equal to the excess of the money-rate of interest (apart from the stamps) over the marginal efficiency of capital corresponding to a rate of new investment compatible with full employment. The actual charge suggested by Gesell was 1 per mil. per week, equivalent to 5.2 per cent per annum.... The idea behind stamped money is sound..."


This is just another illustration of the fact that monetarists view money only as a medium of exchange, but NOT as a store of value. That is the reason why they advocate printing "to replace money that been lost from the system" and continue to assert that this printing is not a destructive act.

Apr 20 07:30 PM

[Lightway:]

Sorry but that blog is an absolutely TERRIBLE source of information. Read some more articles on the site and you'll get an idea of the integrity being displayed there. It's filled with racism, xenophobia, and anti-government conspiracy.

How anyone has taken this seriously and this got so far out of hand is amazing. It's clearly a publicity stunt designed to get more readers to the site. (Therefore generate more ad money by getting more hits).

Do people just not check sources anymore?


On Apr 20 09:36 AM mac123449 wrote:

> The Turner Radio Network has obtained "stress test" results for the
> top 19 Banks in the USA.
>
> The stress tests were conducted to determine how well, if at all,
> the top 19 banks in the USA could withstand further or future economic
> hardship.
>
> When the tests were completed, regulators within the Treasury and
> inside the Federal Reserve began bickering with each other as to
> whether or not the test results should be made public. That bickering
> continues to this very day as evidenced by this "main stream media"
> report.
>
> The Turner Radio Network has obtained the stress test results. They
> are very bad. The most salient points from the stress tests appear
> below.
>
> 1) Of the top nineteen (19) banks in the nation, sixteen (16) are
> already technically insolvent.
>
> 2) Of the 16 banks that are already technically insolvent, not even
> one can withstand any disruption of cash flow at all or any further
> deterioration in non-paying loans.
>
> 3) If any two of the 16 insolvent banks go under, they will totally
> wipe out all remaining FDIC insurance funding.
>
> 4) Of the top 19 banks in the nation, the top five (5) largest banks
> are under capitalized so dangerously, there is serious doubt about
> their ability to continue as ongoing businesses.
>
> 5) Five large U.S. banks have credit exposure related to their derivatives
> trading that exceeds their capital, with four in particular - JPMorgan
> Chase, Goldman Sachs, HSBC Bank America and Citibank - taking especially
> large risks.
>
> 6) Bank of America`s total credit exposure to derivatives was 179
> percent of its risk-based capital; Citibank`s was 278 percent; JPMorgan
> Chase`s, 382 percent; and HSBC America`s, 550 percent. It gets even
> worse: Goldman Sachs began reporting as a commercial bank, revealing
> an alarming total credit exposure of 1,056 percent, or more than
> ten times its capital!
>
> 7) Not only are there serious questions about whether or not JPMorgan
> Chase, Goldman Sachs,Citibank, Wells Fargo, Sun Trust Bank, HSBC
> Bank USA, can continue in business, more than 1,800 regional and
> smaller institutions are at risk of failure despite government bailouts!
>
>
> The debt crisis is much greater than the government has reported.
> The FDIC`s "Problem List" of troubled banks includes 252 institutions
> with assets of $159 billion. 1,816 banks and thrifts are at risk
> of failure, with total assets of $4.67 trillion, compared to 1,568
> institutions, with $2.32 trillion in total assets in prior quarter.
>
>
> Put bluntly, the entire US Banking System is in complete and total
> collapse.
>
> If this is true, and this leak gains traction expect the media blitz
> to discredit it to be swift, ie they wall have cramer and the rest
> of the gang at CNBS and bloomberg radio talking green shoots everywhere
> and that this is total BS, at which point you know it's the truth...

Apr 20 08:28 PM

[HerrHansa:]

If the US government gets shares at the current prices, rather than the share prices when the TARP funds went out, it seems more like an unfair advantage, nearly the same as insider trading.

Apr 21 01:23 AM

[fmr9:]

as if this wasnt foreseeable?? any mutual fund managers that held on to bank stocks or worse purchased more did a great disservice to their investors-any lawsuits???

Apr 21 12:13 PM

[pockyclips ...:]

A no win situation. If the good banks pay back, and the bad banks are exposed, there will be a run on the bad banks. Then those banks will be nationalized.

Apr 21 01:44 PM

[pockyclips ...:]

P.S. I wouldn't doubt that the "good banks" are using our TARP money to short the bad banks. Right out of the J.P. Morgan playbook!

Apr 21 01:48 PM

[DonFurio:]

The reality is that B of A is not going go away. Will there be dilution if the gov't converts some of their pref. shares to common, of course, but the bank is not in danger of being taken over by the FDIC as many SA authors have written about. Do you really think B. Frank would be better at running a complex financial institution such as BAC?

I could care less about what happens this year in regards to the banks' earnings, it's all about the earnings power going forward. Also, the bank lending argument is somewhat distorted because the lending from securitization markets other parts of the shadow banking system are down substantially. Also the Banks, such as BAC continue to raise fees. There are still plenty of options for consumes that don’t want to stay with BAC and pay the fees, but the reality is that most are too lazy to move their accounts. I have no idea what’s going to happen to PPIP, but I’m real glad that J. Dimon in JPM’s earnings call said that he would not be using PPIP bc he’s had a enough of the socialist gov’t intervention.

Apr 21 04:47 PM

[ed233:]

Good gold stocks in Canadian securities and gold bullion ETF'S could provide a hedge against this financial crisis. Here is a selection of stocks on the TSX. with a list of TSX symbols worth investigating:
ABX
AEM
G
YRI
IMG
ELD
XGD
I do own some of these stocks but I am not in any way connected to these companies nor do I have any connection with any brokerage houses that recommend these securities. Looking out for your money LOL.

Apr 21 06:21 PM