Several of the nation's largest banking companies are raising hundreds of millions of dollars by encouraging Wall Street firms to buy stock at a discount through dividend reinvestment plans.
The brokerage firms are using the option in some bank dividend reinvestment plans that allows shareholders to use cash as well as dividends to buy stock at a discount. The firms then resell the shares at market prices, pocketing the difference minus their costs.
Wild Fluctuations
The practice, known as dividend reinvestment arbitrage, has been responsible for increases in short sales and wild fluctuations in bank stock trading.
Banks typically set limits on cash purchases under their reinvestment plans that are too low to make arbitrage trading worthwhile.
But in a policy that encourages arbitrage, banks grant special waivers to securities firms, allowing them to buy blocks of stock exceeding the preset limits.
For example, First Interstate Bancorp, Los Angeles, limits cash purchases of stock through its reinvestment plan to $100,000 per month. But it has given approval to "as many as 10" brokerage houses to buy more than that amount, said senior vice president and investor relations chief Christine M. McCarthy.
Bank insist they are not granting special favors to the brokerage houses, noting they would give permission to any shareholder who asked to trade above the limits. "The only impropriety would be if you did not give all shareholders the same right," said Ms. McCarthy.
Banks Seek Capital Infusion
Dividend reinvestment arbitrage has been taking place sporadically for more than a decade. But this year, equity-hungry banks have launched a number of new plans with cash-option discounts. That has attracted a larger pool of traders and caused arbitrage-related trading volume to surge, analysts say.
Many companies in other industries offer dividend reinvestment plans. But banks have been the most enthusiastic sponsors recently, largely because they are under pressure from regulators to build capital.
In recent months, nearly a dozen major banking companies, including Citicorp and, Chase Manhattan Corp. in New York, and Wells Fargo & Co., San Francisco, have unveiled dividend reinvestment plans with discounts on cash purchases. Citicorp offers a 2.5% discount on shares bought with cash; Chase and Wells give a 3% discount.
Shawmut Joins Trend
"It's a very efficient way to raise capital," said Wells investor relations director Leslie L. Altick.
Shawmut National Corp., Hartford, became the latest major banking company to launch a cash-option dividend reinvestment program when it announced at the end of August a 3% discount on cash purchases.
Of course, some stock sold through dividend reinvestment plans goes to investors who simply want to increase their holdings. But analysts and traders say most of the stock sold through plans with cash-option discounts is connected with large-scale arbitrage.
The amount of money involved in dividend reinvestment is huge. First Interstate put into effect last February a plan featuring a 3% discount on cash purchases.
In the first half of 1992, the plan raised $238.7 million in common equity, most of it apparently linked to arbitrage-related sales.
Swings in Short Interest
Those sales were responsible for some wild swings in First Interstate's stock's trading volume and short-interest ratios. The number of the company's shares sold short rocketed 171% to about 10.4 million between June 15 and July 15 and then fell 91.5% to 890,000 on Aug.15. The volatility was largely due to arbitrage-related trading, sources said.
In addition, some critics worry that new stock issued at a discount dilutes the value of outstanding shares. "Those plans have involved selling too much stock at too low a price," complained John B. Neff, senior vice president of Wellington Management Co., which holds shares of several banks with dividend reinvestment programs.
Banks say they careful control reinvestment to avoid damaging their stock prices. Many set targets each month for the amount of equity they want to raise under the plan.
"We fine-tune it on a monthly basis," said Ms. McCarthy. "We try to manage the program to make it less dilutive by issuing more shares when the stock price is higher."
Traders insist profits from dividend reinvestment arbitrage are not impressive because discounts are slender and costs shave margins further. "Profits are thin, but the arbitrage is done on a big volume," noted one trader.
Profit About $10 Million
No hard figures are available, but traders estimated that the combined profits of securities firms from dividend reinvestment arbitrage will amount very roughly to $10 million this year.
Until recently, most arbitrage-related trading took place on overseas exchanges. "It was less visible, less noisy," explained one arbitrager. Lately, traders have started doing more business in the United States, but many still prefer trading at exchanges outside New York.
About a dozen brokerage houses are said practice dividend reinvestment arbitrage. Bear, Stearns & Co. developed the technique more than a decade ago and, along with Kidder, Peabody & Co., is still the most active player.
But traders say broker-dealers such as Nomura Securities International and Deutsche Bank Capital Corp. have also gotten into the act.
The four firms declined to comment on dividend reinvestment arbitrage.
Arbitrage involves close coordination between banks and securities firms. "They call us at the beginning of each month and tell us what position in shares they want to have," said Ms. McCarthy of First Interstate.
A Series of Transactions
The arbitrage itself involves at least two distinct sets of transactions.
First, an arbitrager must establish himself as a shareholder of record of a sufficient number of shares to buy enough stock to make the practice worthwhile.
The arbitrager ordinarily gets his position by paying fee to, in effect, borrow stock from a big institutional holder. The cost of establishing the position can eat away more than half the dividend reinvestment profits.
The arbitrager carries out what is known as a cross-trade to hedge his position, buying and selling as many as a million or more shares of stock at nearly the same time. This cross-trading can cause trading volume to spike.
For example, on Aug. 5 Bear, Stearns cross-traded one million shares of Wells Fargo on the Pacific Stock Exchange to establish itself as shareholder of record for arbitrage, sources said. Before Wells put into effects its reinvestment plan, its daily trading volume was typically less than 500,000 shares.
Once established as shareholder of record, the arbitrager buys stock at a discount and sells the stock short or manufactures a synthetic short position with options and other derivative securities. The short sale is covered with the stock bought at the discount.
If properly executed, the dividend reinvestment arbitrage is very low-risk. But the technique depends on a complicated series of transactions that must be precisely timed. Failure to execute all the transactions correctly is the single biggest risk in the technique.
