Can You Spell ‘Dilution’? Yes - B-A-N-K-S

The US Banking Stocks are being diluted by the Treasury Plan. Let’s look at how the plan is setup and how that might affect a bank’s common stock, and ultimately the EPS calculation. EPS is calculated based on the shares outstanding, including all conversions, which includes warrants that may be convertible into common stock.

The US government is going to begin the process of injecting taxpayer money into banks.

Here’s some of the details as I understand them :

1. The Treasury gets warrants = 15% of the value of the injection.
2. The cost of the funds = 5% for five years and 9% thereafter.
3. The pricing of the Senior Preferred Shares will be equal to the price of the common stock at the time of the injection.
4. The companies will be able to buy back the Senior Preferred Shares at par after 3 Years.
5. Banks will have restrictions on raising dividends in the future, but may not be forced to cut them.

Let’s look at Bank of America (BAC) for a minute and see what it now looks like:
On 10/7/08 they raised $10bn by offering new shares at $22 ; 455mm shares, most likely to help with the purchase of Merrill Lynch (MER).

With the bank injection program, the banks are getting $250bn in total. They are getting $125mm now and then they are getting another $125mm by the end of the year.

BAC is getting $25bn now and $25bn by the end of the year. Treasury is getting warrants on the common stock = 15% of the amount of the injection. The exact number

You can see from the following graphic that there are going to be roughly 20% more shares of BAC outstanding by the end of the year. It is my understanding that once they receive the Fed Injections they will not be permitted to raise their dividends. It’s also interesting to note that based on the structure of the deal that the lower the share price is, when they get the injection, the more severe the dilution will be. The warrants are priced, based at the time that they get the injections. You can be sure that when they announce the next injections, it will be at an intermediate “high” price for the banks.

I think that BAC’s future earnings will be severely diluted. In addition to the additional shares on their income statement, they will also be required to pay interest on the $50bn in additional capital at a rate of 5% for the first five years and then at a rate of 9% for the next five years.

At a 5% rate the additional interest burden to the corporation will amount to $2.5bn in additional expense by the end of next year. The impact this year will not be as severe as they will only be booking the expense for part of October, all of November and December.

In April of next year when they report first quarter earnings, they will have the full impact of the $2.5bn of additional interest expense, running through their income statement. If the economy does not pick up or their are additional writeoffs, resulting from the mortgage crisis, or they are not able to make loans at acceptable terms then their earnings could be negatively impacted.

There could be some positvie offsets from investing the $50bn in new loans. The cost of the new loans that the bank will make will have to earn in excess of 5%, otherwise it’s not profitable for BAC to make the loans. In fact, the funds will have to be loaned out at a rate higher than five percent, to account for the 9% back end cost of the governments Senior Preferreds.

In the cheering of the stock market and the hoopla of celebrating the recovery of the financials, you can see that the stocks are becoming more diluted. I’ve applied this analysis to the BAC, but I would assume that most of the others are all in similar positions, varying by degree, based on the size of their existing capital structures.

I’m not sold that the equities of the bank stocks are the best place to invest at the current time. Unless the economy improves significantly over the next year, I think that equities of these institutions could continue to be under stress.

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