Bank Dilution Looms for 2010

Investors in financial shares have fared well this year, as almost all are significantly higher than their March lows. Those that bought shares near the lows have obviously fared better than the original owners, But the time has come to be wary. Dilution looms, again, on the horizon.

Banks have had ready access to capital this year as they attempt to work through their myriad mistakes. First, the Government provided needed support, then hungry investors started lining up to buy financial secondary offerings. The result was the same: loans were written off, capital depleted, new capital acquired and original investors diluted. Painful only for the original owners.

While mortgage and credit card loan delinquencies are still at record levels, commercial real estate lending was poorly underwritten and is now showing serious weakness, another capital consuming issue is raising its head. On January 1, 2010, FAS167 will take effect unless delayed. The effect will be that banks must set aside additional capital to support off-balance-sheet credit card receivables and other securitizations. Whether or not the assets are brought back on the balance sheet or not, more capital must be found to support the potential risk of implied recourse. The big credit card issurers -- JP Morgan (JPM), Citigroup (C), Wells Fargo (WFC), Bank of America (BAC) and Capital One (COF) -- will be affected to varing degrees. Since current capital isn't plentiful, they will sell more shares and dilute the current base.

Several days ago, First National Nebraska, a moderate sized regional bank with a large credit card operation, filed to sell $250 million of new common and preferred securities. The major reason given for the decision was the need to support off-balance-sheet credit card securitizations. The decision to sell new shares was a difficult one for First National, as it is owned, almost exclusively, by one family. They felt the need, and pressure, to dilute themselves to comply with FAS167. What do you think the professional, non-owner, managers will do? Yes, sell new shares to whom ever will buy them, Government or public.

Setting aside concerns about the remaining potential loan losses and adequacy of loan loss reserves, capital raising is coming again to the banks courtesy of the accountants and transparency. Bank shares will be worth less in 2010.

Disclosure: William Kabourek has no ownership positions in the above named companies

Comments

[satyr]

A few things could use some qualificaiton or clarification here. First off, the current problems in commercial real estate are not so much the result of poor underwriting as the falling value of the assets. I would not blame underwriters for not anticipating that collateral would lose 30% of its value. Second, it should not be assumed that capital levels will be bolstered by stock sales. There are other means for accomplishing this, so until a financial institution announces a stock sale, I would not suppose it. And, third, when a company sells shares, it does not necessarily result in dilution, other than in the very short run. Remember, they get cash in return for the shares, and this is a new asset owned by all shareholders. In turn the cash will be exchanged for other assets that generate income. This should not be characterized as a negative, because if capital is properly deployed, it is actually a benefit to existing shareholders.

2009 Nov 19 08:33 PM

[apppro]

Maybe a know-nothing pundit dilution for 2010 would be more appropriate.

2009 Nov 20 07:42 AM

[William Kabourek]

thanks for the comments. First, the thrust of my thought was aimed at the looming need for additional capital to support off balance sheet assets, not the ongoing need for capital replensihment to fill the bad lending hole. Second, on commercial real estate, there wouldn't be increased provisioning for commercial real estate loans if the underwriting would have required more equity, greater debt service coverage, and firmer lease up requirements before construction commencement. The values have definately fallen, but lenders would be in a much better position had they maintained the more stringent terms of past decades.

Regarding the upcoming dilution, yes I understand that in return for the shares you get cash and the opportunity to reinvest those proceeds in assets that generate income. If banks were raising cash to fund organic growth that would be acceptable. But in the case of FAS 167, the off balance sheet earnings stream is already included in the P&L and , since loan demand is not robust, the new cash is apt to be invested in low yielding securities. Therefore, current shareholders are not going to get a big uptick in earnings from the new money, but they are going to have to share future earnings with all the new shareholders. Coming dilution remains bad for commercial bank shareholders.


On Nov 19 08:33 PM satyr wrote:

> A few things could use some qualificaiton or clarification here.
> First off, the current problems in commercial real estate are not
> so much the result of poor underwriting as the falling value of the
> assets. I would not blame underwriters for not anticipating that
> collateral would lose 30% of its value. Second, it should not be
> assumed that capital levels will be bolstered by stock sales. There
> are other means for accomplishing this, so until a financial institution
> announces a stock sale, I would not suppose it. And, third, when
> a company sells shares, it does not necessarily result in dilution,
> other than in the very short run. Remember, they get cash in return
> for the shares, and this is a new asset owned by all shareholders.
> In turn the cash will be exchanged for other assets that generate
> income. This should not be characterized as a negative, because
> if capital is properly deployed, it is actually a benefit to existing
> shareholders.

2009 Nov 20 07:42 AM

[William Kabourek]

I won't argue with you that community banks have serious real eatate lending problems, are capital shy, and many will fail. But don't kid yourself that big banks are adequately capitalized. Loan loss reserves are judgement calls and the provisioning is light in my opinion. A telling statistic would be loan recoveries. A comparison with past disaster cycles will show that the percentage recovered after charge off is much worse and should result in a larger reserve.

there's more downside risk than upside potential in big bank stocks.


On Nov 20 05:55 AM bbro wrote:

> Your blanket statement on dilution is misquided and misinformed.
>
> The larger banks have enough capital ( and more importantly pre
>
> provision earnings) it is the smaller banks that don't have enough
>
> capital that haven't reserved enough and don't have enough pre<br/>provision
> earnings.....

2009 Nov 20 07:53 AM

[Dr. Roberts]

bbro is correct and his info is more informative than Mr. Kabourek's lumping of the major issuers together. NO WAY will WFC dilute shareholders further. Take that to the bank! At least the article states he is not short the majors.

2009 Nov 20 11:02 AM