Banks unveil their latest desperate strategy for self-preservation.

Commentary about business and finance.
April 26 2008 7:34 AM

The Age of Grand Dilution

Banks unveil their latest desperate strategy for self-preservation.

Watching CNBC can be a little like watching the movie Groundhog Day. Every trading day seems to bring a replay of a show we've seen before: A large financial institution, maimed by self-inflicted wounds and in need of capital, raises billions in cash from investors on onerous terms. The trend started last fall when New York-based investment banks such as Citigroup and Merrill Lynch sold hunks of themselves to sovereign-wealth funds and Persian Gulf investors at a steep discount. Now it's moved from Wall Street to Main Street. Last Monday, Cleveland-based National City Corp., America's 10th-largest bank, announced it was raising $7 billion. In a complicated deal, investors—including the private-equity firm Corsair Capital and existing shareholders—essentially agreed to acquire 1.4 billion shares at $5 apiece.

Such transactions have typically been hailed by market cheerleaders as votes of confidence. After all, they prove that sophisticated investors are willing to plunge billions of dollars into a foundering sector.

Advertisement

But these life preservers exact a heavy cost: dilution. Most Americans experience dilution at bars, when unscrupulous bartenders cut top-shelf alcohol with excessive amounts of tonic or juice in mixed drinks. In recent months we've been feeling it in our wallets, as inflation (up 4 percent in the year that ended in March) has eroded wages. Now it's Wall Street's turn.

Dilution can be defined as the sudden realization that an asset's market value isn't quite as great as had been advertised. Before the dilutive financing transaction, National City had about 635 million shares of common stock outstanding, which the market valued at $8.33 a share as of Friday, April 18. With the flood of new shares to be issued—and with the new buyers willing to pay only $5 per share—the ownership stakes of prior shareholders have been watered down significantly. "We've estimated the dilution of current shareholders at approximately 70 percent," CEO Peter Raskind told me. If you owned shares worth 10 percent of the company last month, they'll be worth only 3 percent of the company next month.

Raskind took the helm of National City last July, just when its world was about to be rocked. In ordinary times, companies seeking to raise funds sell bonds or sell common shares at something close to the market price. But as Raskind noted, "These are not ordinary times. And furthermore, we are not in an ordinary position." Like other banks, National City racked up consecutive quarterly losses thanks to rising amounts of bad debt, and was bracing for further losses. Given that it had to raise capital quickly—to stay in compliance with regulatory requirements and to reassure customers and the markets that it had sufficient cash—selling stock at a huge discount was "the least unattractive" alternative.

The dilution at National City isn't the worst. In March, Thornburg Mortgage raised $1.35 billion through a transaction that effectively diluted shareholders by 94.5 percent. And it's not the biggest. On April 22, while the market was still digesting National City's deal, the Royal Bank of Scotland (which, these days, is neither royal, nor particularly Scottish, nor, judging by recent results, much of a bank) announced a highly dilutive $24 billion offering.

Accepting dilution while raising cash is an admission of failure and a mark of embarrassment—like pawning the family silver to pay off gambling debts. "It is not something that we are proud of," said National City's Raskind. But for shareholders, there is something of a silver lining. Investors, employees, and politicians alike were outraged when former CEOs such as Chuck Prince of Citigroup and Stanley O'Neal of Merrill Lynch, who presided over financial train wrecks that required dilutive capital-raising efforts, walked away with mammoth retirement packages. Raskind, who owns 287,617 shares of National City, has suffered the same proportional financial harm as an investor with 50 shares.

Raskind also owns options on more than 1 million shares of National City. Investors value stocks by placing a multiple on a company's earnings per share. Since National City is effectively tripling its number of shares, any future earnings will be distributed across a much broader base. In order to report earnings of $1 per share, predilution, the company would have had to earn $635 million. Now it'll have to make $2 billion. According to National City's proxy filing, Raskind's options, some of which expire in 2010 and 2011, will generally have value only if the company's stock hits $30. If the stock doesn't quintuple in the next three years, many of Raskind's options won't be worth the pixels they're stored on. In this case, at least, there's no diluting the toll shareholder dilution will take on the CEO's personal finances. "The stock options that I may have been granted in the past are way, way out of the money, and probably will be for a long time," Raskind said. "And that's the way it should be."

A version of this article also appears in this week's issue of Newsweek.

TODAY IN SLATE

Politics

Blacks Don’t Have a Corporal Punishment Problem

Americans do. But when blacks exhibit the same behaviors as others, it becomes part of a greater black pathology. 

I Bought the Huge iPhone. I’m Already Thinking of Returning It.

Scotland Is Just the Beginning. Expect More Political Earthquakes in Europe.

Lifetime Didn’t Think the Steubenville Rape Case Was Dramatic Enough

So they added a little self-immolation.

Two Damn Good, Very Different Movies About Soldiers Returning From War

Medical Examiner

The Most Terrifying Thing About Ebola 

The disease threatens humanity by preying on humanity.

Students Aren’t Going to College Football Games as Much Anymore, and Schools Are Getting Worried

The Good Wife Is Cynical, Thrilling, and Grown-Up. It’s Also TV’s Best Drama.

  News & Politics
Weigel
Sept. 19 2014 9:15 PM Chris Christie, Better Than Ever
  Business
Moneybox
Sept. 19 2014 6:35 PM Pabst Blue Ribbon is Being Sold to the Russians, Was So Over Anyway
  Life
Inside Higher Ed
Sept. 19 2014 1:34 PM Empty Seats, Fewer Donors? College football isn’t attracting the audience it used to.
  Double X
The XX Factor
Sept. 19 2014 4:58 PM Steubenville Gets the Lifetime Treatment (And a Cheerleader Erupts Into Flames)
  Slate Plus
Slate Picks
Sept. 19 2014 12:00 PM What Happened at Slate This Week? The Slatest editor tells us to read well-informed skepticism, media criticism, and more.
  Arts
Brow Beat
Sept. 19 2014 4:48 PM You Should Be Listening to Sbtrkt
  Technology
Future Tense
Sept. 19 2014 6:31 PM The One Big Problem With the Enormous New iPhone
  Health & Science
Medical Examiner
Sept. 19 2014 5:09 PM Did America Get Fat by Drinking Diet Soda?   A high-profile study points the finger at artificial sweeteners.
  Sports
Sports Nut
Sept. 18 2014 11:42 AM Grandmaster Clash One of the most amazing feats in chess history just happened, and no one noticed.