Bank Holding Company Stockholders: Greater Dilution Awaits

Includes: BAC, C, JPM, WFC, WMIH
by: Roger Ehrenberg

During my years as a derivatives and capital structuring professional, I spent a lot of time working with my teams to develop versions of the "holy grail" - tax-deductible equity. In short, when corporations are seeking to raise funds, the goal is to receive equity credit from the rating agencies while incurring a financing cost more akin to debt.

This is nowhere more important than with regulated financial institutions, which have mandated minimum capital ratios which are heavily scrutinized by both regulators and the analyst community. Bank holding companies have been on the leading edge of so-called "hybrid" equity issuance, and have historically been among the largest issuers of such paper.

Without question, hybrid paper has created a form of both regulatory and economic arbitrage, where "equity" can be issued at debt rates. This has been courtesy of bank regulators, ratings agencies and the IRS, from whom opinions are sought to ensure the amount of equity credit received and the tax-deductibility of the structure. It could only be that such an arbitrage opportunity could exist when three different bodies are involved in the treatment of such instruments.

There is a limit to this nirvana, however: only so much of this paper can count as equity before the regulators and ratings agencies call bullshit. And if you believe the story line in a recent Wall Street Journal article - and I do - then this breaking point has pretty much been reached:

U.S. banks and brokers trying to raise capital with hybrid securities have turned to issuing the instruments so frequently they risk losing the securities' capital-raising benefits.

If the banks decide to sell more of these securities, which are a blend of equity and debt, they may not be considered capital by rating firms. That in turn could limit financial firms looking to raise more funds to bolster battered balance sheets.

The companies are then likely to tap other avenues that pose their own disadvantages, such as selling common stock -- which current shareholders wouldn't welcome.

The real issue here isn't that the banks are opportunistically trying to raise cheap capital and get equity credit, though this has been the "sale" from Wall Street firms to the banks during calmer times, but that banks need to raise equity, real equity - and fast. Damaged balance sheets face banks of all sizes across the U.S. and the UK, and they either need to massively shrink their assets and de-lever (which causes a flood of paper to further depress asset prices), raise real equity capital or both.

It appears that the equity issuance side of the equation will become more costly, and greater numbers of these sales will be in the form of expensive and dilutive common stock. This is clearly not good for existing common stockholders, who will bear the brunt of this change in issuance strategy. Whether it is through public market issuance or via private sales akin to Washington Mutual's (NYSE:WM) deal with TPG or the announced Bradford & Bingley transaction in the UK, common stockholders will be hurt - badly.

It brings me back to my early days at Citibank (NYSE:C) when Prince Al-Waleed spent a cool $590 million to buy up what turned out to be one of the best investments of all time (even in light of current problems). We have only witnessed the tip of the iceberg.