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Wall Street Whispers - Get Set for More Dilution

Bank-stock investors should prepare for more dilution in the coming months, with midsize companies appearing the most vulnerable to new offerings.



) -- There's a big issue the market hasn't been whispering about much, but it probably should be: the wave of dilution that may take place for bank-stock investors -- particularly midsize firms -- in the months ahead.

The industry has been on a long-running capital-raising spree to cover losses from the financial crisis. Since the start of 2007, financial firms have raised $590 billion by offering 147 billion new shares to the market, according to SNL Financial. Perhaps unsurprisingly, banks have raised the most capital and issued the most stock in the most dilutive manner since crisis-related offerings began to emerge. Other types of financial firms -- asset managers, broker-dealers, insurers and the like -- have managed to obtain much more value for each new share issued.

New regulations from Congress and new

capital standards that will emerge from the Basel Committee promise to expand the financial float further.

Recent deals to secure funds from private-equity firms for

Sterling Financial

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Pacific Capital



Hampton Roads


-- in which the Treasury Department agreed to haircuts on taxpayer investments -- show that capital is desperately needed by some banks, even before new rules are decided, much less put into place.

Private-equity titans have been eager to take stakes in small banks, or swallow them whole if the price is right. Big banks tapped the market early and frequently for capital in exchange for new stock. But midsize competitors haven't done so nearly as much, and their capital levels give cause for concern.

According to a survey released Thursday by the consulting firm Grant Thornton, 22% of bank executives think they'll need to raise more capital within the next year. (Another 11% had already done so.)

John Ziegelbauer, national managing partner of Grant Thornton's Financial Institutions practice, noted that there is "a lot of uncertainty" in regards to finreg. Those that raised funds early may have done so "to ensure that they have a sufficient amount under any new rules that are created."

(House and Senate negotiators early Friday completed an

overhaul of banking regulations


The 67% of executives who said new capital raises are unlikely may simply be unsure of how reform measures will play out. They may also be unwilling to admit the possibility of additional dilution after the pile-on of offerings in recent months, and amid the bank-stock selloff that's been taking place.

Indeed, bank stocks were hit anew on Thursday by a report that the industry may get stuck paying for the liquidation of

Fannie Mae



Freddie Mac


. Banks to which the rule would apply -- those with at least $50 billion in assets -- were generally down 2% to 3% by the end of the day, and have been on a downward trend since the finreg negotiations started gaining traction in April.

One particularly

troubling amendment in regards to capital was added to the finreg bill by

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Sen. Susan Collins, and would force banks to exclude trust-preferred securities from Tier 1 levels. Moody's estimates that rule alone would require banks to raise $118 billion in new funds if adopted as-is, though the original language will likely be softened to give banks five to 10 years to adjust.

While big banks are by no means exempt from new capital rules, small-to-midsize competitors appear to be the most exposed to dilution in the near term. They hold the most trust-preferred securities, are facing much bigger issues with commercial real-estate and other types of bad loans and have lagged larger competitors in stock offerings.

Furthermore, their key capital levels are lower than very big or very small firms. Publicly traded U.S. banks with $51 billion to $499 billion in assets have a Tier 1 common risk-based capital level -- which excludes trust preferreds -- of 8.5%. That's 500 basis points less than the $500 billion-plus titans, and a wide margin away from the 11.7% level of tiny peers with less than $50 billion in assets.

The spread between capital ratios that include TruPS and those that don't is also wider for midsize firms than it is for bigger and smaller ones -- indicating that they have the most work to do when it comes to the Collins amendment.

It may be worth looking at the first wave of heavy issuance for clues to additional offerings could play out.

With better access to Wall Street, the Big Six banks jumped in early with offerings to cover loan losses, and then again to rid themselves of the Troubled Assets Releif Program. All told,

Bank of America

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JPMorgan Chase

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Wells Fargo

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Goldman Sachs

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Morgan Stanley

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have tapped the market nearly two dozen times for new capital in exchange for common stock since the start of 2007. Those efforts represent 27% of the entire financial industry's since that time, reeling in $160.5 billion in fresh funds and more than doubling their float over the past three and a half years.

Excluding Citigroup -- the only large bank to have converted the government's giant preferred stake into common stock -- the effect is slightly less severe, with 30% dilution. But that still represents a whole lot of new stock.

Congress seems sure to require banks to hold more cash against derivatives, risky assets and trading practices. Basel seems sure to require much higher levels than the previous declaration, with stricter terms for trading as well.

It's yet to be seen what the tangible impact of the financial reform bill will be on capital levels or when any of the new rules will take effect. But it seems evident that, as well capitalized as the industry seems today relative to historical levels, banks will need to have even more cash on hand. Hopefully the market hasn't become too bloated to handle it.

Grant Thornton's Ziegelbauer indicated that some offerings may represent opportunities for selective investors.

"They may want to use the extra capital to expand their bank's geographic footprint through an FDIC-assisted transaction or possibly other acquisitions," he said.

-- Written by Lauren Tara LaCapra in New York