For the growing number of banking companies that are selling shares to boost capital, exchanging securities with large investors has emerged as the best weapon to combat dilution of common stock.
Bankers have had surprising success persuading preferred shareholders to swap their investments for common stock in below-par transactions. This lets the company use accounting rules to reduce the dilutive impact of other capital-raising efforts while making certain income lines look better.
Such deals are especially attractive to companies that were ordered to raise common equity after the Treasury Department's stress tests.
Bank of America Corp. said Tuesday that it had swapped common stock for about $9.5 billion in perpetual preferred stock. Other companies, including KeyCorp, SunTrust Banks Inc. and Zions Bancorp., are planning similar transactions.
Though it may seem quizzical for preferred shareholders to give up lucrative dividends, observers said there are several reasons why the interests of buyers and sellers are converging.
Marshall Front, the chairman of Front Barnett Associates LLC, said preferred shareholders are allowed to buy common stock at discounts to current market values, giving the investors a convenient exit. "The incentive is that profits can be booked right away," he said.
Further, observers said there are increasing signs of inflation and the potential for interest rate hikes, which may also motivate preferred shareholders to swap. Just like bonds, preferred stock generates a fixed payment that is susceptible to rising interest rates. When the rates rise, the underlying value of the shares fall to offer investors a better rate. However, those who swap preferred shares for common stock could reap significant gains if the banking industry recovers over the next year or two.
James Abbott, an analyst at Friedman, Billings, Ramsey Group Inc., said that holders of noncumulative preferred shares could have added incentive to exchange, because banking companies are allowed to stop paying dividends on those securities indefinitely.
"There is certainly a reasonable amount of concern about banks' cash flows," he said. "So there is a risk to holding those shares."
Finally, some preferred shareholders were able to buy their securities at steep discounts when the initial investors became disenchanted with their holdings late last year.
One asset manager, who asked not to be named, touted the fact that he bought B of A preferred shares at $12 apiece and was able to exchange each one for $16 of common stock.
"There are a lot of holders who stand to benefit that way," the manager said.
Such receptiveness is good news for banks, many of which had very little preferred stock issued just over a year ago. Including shares issued to Treasury, the 10 biggest banks saw levels of preferred stock jump six-fold in the first quarter of 2009 compared with a year earlier, to more than $243 billion, according to public filings.
Eight of those banks are now looking for ways to boost common equity without massive dilution for common shareholders. Though the conversions cause dilution by increasing common shares outstanding, the moves partially offset the effects of dilution by eliminating dividends on the preferred shares.
Abbott said exchanging at steep discounts would boost book value, because the banking company would be able to significantly reduce liabilities without a corresponding reduction in its assets.
"The difference between the two would boost tangible common equity," he said.
SunTrust is looking to use the proceeds from a common stock offering to repurchase about $1 billion of preferred securities at discounts of up to 40%. KeyCorp has swapped common stock for about $154 million of preferred stock, and the company said it could pursue more exchanges. Zions, which was not required to participate in the stress test, has launched a tender offer to extinguish preferred shares.
Observers said that converting preferred shares at a discount to par provides a bigger offset to dilution.
Under accounting rules clarified this year by the Financial Accounting Standards Board, the discount embedded in the exchange can add to the net income available to common shareholders. That could prove beneficial to bankers who are selling common stock or shedding assets to further bolster capital levels.
The discount does not filter into the income statement and would not pad retained earnings or capital levels.
However, "it would still be a pleasant surprise," said Dorsey Baskin, a partner in the national professional standards group at Grant Thornton LLP. "You could have a kicker to EPS, and having any pickup there looks good. It could allow a bank to take a loss on something they may otherwise not want to take, or it could offset other dilutive actions."
