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The Age of Grand Dilution Banks unveil their latest desperate strategy for self-preservation.

By Daniel GrossPosted Saturday, April 26, 2008, at 7:34 AM ET

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 10^th-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.

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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.

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.

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Daniel Gross is the Moneybox columnist for Slate and the business columnist for Newsweek. You can e-mail him at and follow him on Twitter. His latest book, Dumb Money: How Our Greatest Financial Minds Bankrupted the Nation, has just been published in paperback.

COMMENTS

Notes from the Fray Editor

The first post below led to a fascinating discussion, correctly described by participant Dayslight as "a thread worth reading all the way through for a fuller perspective on what makes our currency tick."

Comments from the Fray

The US is an open economy where anyone with the bucks can participate; have access to the courts if their investment is compromised; and reside in relative safety--if you can pay moderate rents. Banks are chartered by governments. Our collective wealth is held in trust behind an offensive nuclear shield. That wealth belongs to the person with the keys to both doors. The combination to the vault really doesn't matter that much...it's just there to build public confidence.

--le-idiot

(To reply, click here)

The management of these failing banks made incredibly stupid bets, and lost, and their shareholders are paying the price. The stockholders are lucky that they're banks; if they were airlines, they would be out of business, with nothing, but at least they're getting 30 cents on the dollar or so.

If the stockholders had any sense, they would fire the boards that let the grossly incompetent managers destroy these companies. But I guess these shareholders are just like the citizens of America, who every two years re-elect the directors, I mean Congress, who have rubber-stamped every disastrous decision by the country's "CEO". Our CEO, with the approval of our pathetically self-serving and ignorant Congress, has wasted trillions of dollars over the past 7 years, transforming a world-leading economy that was running surpluses into a second world, debt-ridden country that not only desperately needs loans and cash infusions, but talks about blocking those investors (who now have our money) from bailing out our banks. So where else will these banks turn to to get their needed capital?

--kgsbca

(To reply, click here)

Note that the funding/dilutions referred to in the article were the work of CEOs. Now why is that? CEOs are hired by the stockholders through their representatives, the Board of Directors, to manage the business of the company. On the other hand, the sale of all or part of the company itself, or the distribution of profits is properly a function of that Board, not of one of the hired hands. If, to use a more humble example, you owned a candy store and hired some guy to run it, you would be mighty distraught is you entered the store one day to find that the manager had sold your store instead of selling the candy. We need to get our thinking straight about what the legitimate powers and responsibilities of the CEOs (employees) and the Boards (owners and owner's proxies) are. Recommended first steps (in my view, anyway) are to allow only major stockholders to hold positions on the Board of Directors (so their investments are at the same risk as the cohort of stockholders) and to publish to the stockholders a full copy of the employment contract of a potential new CEO for perusal and approval before that CEO is hired. It is long past time for powers to be appropriately assigned.

--PhilfromCalifornia

(To reply, click here)

(4/30)

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