Gross: The Age of Grand Dilution

Watching CNBC can be a little like watching the movie "Groundhog Day." and no, it's not because Bill Murray has replaced Bill Griffeth as the maitre d' on "Power Lunch." Rather, 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, raising a 10-figure sum of cash from investors on onerous terms. The trend started last fall with New York-based investment banks like Citigroup and Merrill Lynch, which 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., the 10th largest bank in the nation, 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 a price of $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.

But these life preservers bear 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 strong 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 NEWSWEEK. 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. Like his Dartmouth classmate General Electric CEO Jeff Immelt, who succeeded Jack Welch in early September 2001, Raskind assumed ultimate responsibility for his company 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 notes, "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 baddest—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. See what I mean by "Groundhog Day"?

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 like 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."

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