Goldman Sachs Raids the Cookie Jar

There was an interesting note put out by Goldman Sachs (GS) on Thursday evening (6/12/08) wherein GS claimed that Keycorp (KEY) was in good company and that several other banks would follow suit. As we all know, Keycorp cut its dividend by 50% to $0.75 and issued stock (dilution) in order to raise $1.65B (gross) in fresh capital. 

Goldman Sachs targeted the following banks: Bank of America (BAC), Comerica (CMA), Fifth Third Bancorp (FITB), Regions Financial Corp (RF) and one of Goldman's favorites, SunTrust (STI). 

My daughter likes to bake cookies. My granddaughters and I love to eat them. This reminded me of a deal that I had with my sister when I was a kid. All the whole cookies belonged to her. All the broken cookies were mine. So we made the same deal with my daughter. As my daughter took the trays out of the oven we got very busy inspecting all the cookies. Lo and behold we had all the broken cookies to fill our tummies to our hearts content. It's amazing how fragile hot cookies are when you handle them! 

The banking and financial sectors are extremely fragile these days. It doesn't take much handling from Goldman Sachs to chip away at a bank's shares. Full disclosures by GS analysts are superfluous because in theory there is no connection between the various GS departments and their clients. 

The Keycorp Cutter 

Keycorp gave a very detailed press release concerning both the dividend cut and the new equity, yet GS reaps the reward by disseminating half baked information. It is self explanatory so here's an excerpt:

CLEVELAND, June 12 /PRNewswire-FirstCall/ -- KeyCorp today announced a series of steps to preserve and enhance its capital strength in response to a previously announced ruling by a federal court in a dispute over tax treatment of a segment of its leveraged lease portfolio. Although the announced steps are being taken primarily to offset the accounting effects of the adverse court ruling, they will also help maintain the company's strong capital ratios and position it to better address both current economic conditions and future growth opportunities… 

Finally, it is the Board's current intention to reduce the dividend on KeyCorp's common shares by 50 percent commencing with the third quarter 2008 dividend, to an annualized dividend of $0.75 per common share. The dividend reduction will result in Key retaining approximately $200 million of capital annually (pro forma, after giving effect to the anticipated capital raise).

You would think that the Goldman boys could figure out that Keycorp just lost a very big tax related lawsuit. Nope, the boys applied a cookie-cutter (lack of originality or distinction) analogy and didn't seem to realize that this has nothing to do with sub-prime, the economy or whatever else is plaguing the financial sector these days. The court case specifically pertained to Keycorp's leveraged lease portfolio tax practice. 

Arguably you might conclude that the dividend cut is related to the bank's 'dire condition' being that the fresh equity covers the entire legal bill. Well, not really. If you think about it, due to the same judgment, earnings will be less in the future as well. If Keycorp has to pay higher taxes on its leases, this means lower earnings. If you add up the numbers, the only way it paid out higher dividends until now was by stiffing Uncle Sam. That's how I see it. I'm not referring to the actual court case; I don't have a legal opinion, just opining on the outcome. 

If They Are Whole, Break Them 

I looked up our research to see if BAC, CMA, FITB, RF and STI were in court with the State or IRS over the same issue and found nothing. I'm not calling the $14.7M BAC settlement with the IRS regarding City of Oakland bond rigging a trivial issue, it's just a different recipe. Regions Financial Corp just won its lawsuit against the IRS but that has no dough. What a shame; those cookies are whole so I guess we will have to do a closer inspection. 

Yup, they're broken. With the upcoming interest rate hikes, this will lead to lower demand which in turn will lead to lower commercial real estate prices which in turn will lead to higher commercial defaults which in turn spell hard times ahead for the aforementioned banks. After all, we didn't 'break' them on the first round of sub-prime inspection so we will take a closer look at their commercial texture. For instance, STI prides itself for having stayed out of the sub-prime mess for the most part and instead relied heavily on commercial real estate. Ah-ha, now we know where STI crumbles. 

As an aside, BAC refuted Goldman's assertions just this week; the Goldman boys just weren't paying attention…probably because they were busy counting the chocolate chips in their cookie collection or something along those circles. 

Cookie Press 

My granddaughters aren't old enough to read press releases so I can't run the above (FirstCall) quote through a kids' comprehension test. Apparently Keycorp is familiar with the crumby (crummy) attention span of others so CEO Meyer handedly kneaded the press release summary into two short paragraphs:

"We are taking these actions to preserve and enhance our balance sheet strength," said KeyCorp CEO Henry Meyer. 

"If it had not been for the adverse court ruling on our tax treatment of a leveraged lease transaction, we probably would not have considered the capital raising actions", Meyer continued. "But the ruling forced our hand and prompted the decision to build on our strength with a capital raise, one that we think not only is prudent in light of the economic climate, but also is an appropriate move as we look to the future of the enterprise."

"The ruling forced our hand" is the key. I wonder who is forcing Goldman's hand into the cookie jar! 

Disclosure: Associates long various BAC instruments and common stock.

Comments

[mariposa:]

There will be various drum beats from the financial industry, along with denials by the actual companies, until it seems perfectly normal to cut dividends, and it is in the interest of shareholders.
Yet there are those who have held on because of the dividend.
Think I need a trailing stop on dividends!

2008 Jun 15 08:06 AM

[Medici:]

Monday morning's victim will be Wachovia add them to the cookie cutter list courtesy ala Goldman

2008 Jun 15 09:59 AM

[oldman:]

How has PNC avoided the same issues which they also had?

KeyCorp today announced a series of steps to preserve and enhance its capital strength in response to a previously announced ruling by a federal court in a dispute over tax treatment of a segment of its leveraged lease portfolio.

2008 Jun 15 10:01 AM

[Stewie:]

FITB does have the same issues:Although this isn't as large as KEY's loss it is only one of what could be large numbers of lease backs they hold. Also remember KEY will likely appeal that decision so their capital may not be affected for several months. In my opinion KEY used the court decision as a single event excuse to try and cover-up multiple problems. Below is a link to the FITB Federal Court decision.

www.usdoj.gov/opa/pr/2...

2008 Jun 15 11:24 AM

[oldman:]

Here's the PNC & Key decision.

www.usdoj.gov/opa/pr/2...

2008 Jun 15 11:57 AM

[CrossProfit_:]

Stewie,

Thanks for the link, know that. The $5.6M is peanuts. It is the $900M, mentioned in the article that should be of concern. However, FITB deposited on account with the IRS back in 2005 most of the tax due. This means that if they lose, they don't pay the interest on the claim. If there is anything else to pay it would be a small amount. If they win, they get back $380M+(?) and interest.

Posting the full text:
During May 2005, the Bancorp filed suit in the United States District Court for the Southern District of Ohio related to a dispute with the Internal Revenue Service concerning the timing of deductions associated with certain leveraged lease transactions in its 1997 tax return. The Internal Revenue Service has also proposed adjustments to the tax effects of certain leveraged lease transactions in subsequent tax return years. The proposed adjustments, including penalties, relate to the Bancorp's portfolio of lease-in lease-out transactions, service contract leases and qualified technology equipment leases with both domestic and foreign municipalities. The Bancorp is challenging the Internal Revenue Service's proposed treatment of all of these leasing transactions. The Bancorp's
original net investment in these leases totaled approximately $900 million. The Bancorp continues to believe that its treatment of these leveraged leases was appropriate and in compliance with applicable tax law and regulations. While management cannot predict with certainty the result of the suit, given the tax treatment of these transactions has been challenged by the Internal Revenue Service, the Bancorp believes a resolution may involve a projected change in the timing of the leveraged lease cash flows.

Recently issued FSP FAS 13-2, which was effective as of January 1, 2007, mandates that a change or projected change in the timing of lessor cash flows related to income taxes generated by leveraged lease transactions, excluding interest and penalty assessments, will
require a lessor to recalculate the rate of return and allocation of income to positive investment years from inception of the lease.

Upon adoption of FSP FAS 13-2 on January 1, 2007, the Bancorp recorded a $96 million after-tax charge to retained earnings related to its portfolio of leveraged leases. The amount of this reduction will be recognized as income over the remaining term of the affected leases.

During the first quarter of 2007, the Bancorp made deposits of $386 million with the IRS to mitigate the risk associated with tax years
currently under audit. These deposits enable the Bancorp to stop the accrual of interest on any tax deficiency, to the extent of the deposit, if the Bancorp is not ultimately successful.

2008 Jun 15 12:17 PM

[Stewie:]

That's a good point, but since the $380 million is on deposit isn't FITB still presently booking that as net capital and wouldn't it plus additional funds disappear if they lost the tax case.

Was FITB trying to force a negotiation by taking a single transaction to jury trial, it that was their plan it didn't work out very well.

Thanks for responding.

2008 Jun 15 12:38 PM

[CrossProfit_:]

Stewie,

Point 1) - Not sure, will have to look it up.
Point 2) - Could be, so it backfired, big deal. All it really means is that they have to pay the tax upfront instead of deferring. In any case, they don't have to come up with the cash. But point #1 (capital) has to be looked into.

2008 Jun 15 12:49 PM

[makemoney2323:]

So do you think KEY is oversold, due to the market looking at their stock issuance as a sub prime problem, when it could be just a 1 time event?

2008 Jun 15 02:19 PM

[Reinko:]

Ah that leveraged stuff, wonderfull...

When a bank is leveraged 25 fold with respect to market cap and (borrowed or invester) assets, then just a 4% decline gives rise to a total wipe out of all market cap.

This explains that 'just a tax dispute' in 'just a segment of the leveraged department' gives rise to 50% less dividend and dillution of outstanding shares...

There are many ways to measure leverage but market cap to assets is one of my favorites because the banks are constantly telling that they are working on the leverages, but when stock value declines those leverages are still climbing...

Welcome to the world of Alan Greenspan!

2008 Jun 15 03:44 PM

[messy:]

From this article, it seems as if Goldman Sacks is a little jealous of JP MORGAN BANK getting help to buy Bear Stearns. Its a way of getting even with the banking industry. We will probably see more of this kind of thing in next few months, as a result and time will tell.

2008 Jun 15 04:59 PM