As we enter the first trading week of 2008, many of the most beaten-down sectors of the market -- the homebuilding and financial sectors, mainly -- are hoping to start fresh after a 2007 that left them rattled to the core.
While the full extent of the credit crisis, now nearly one year old, is yet to be determined, many of the financial sector's embattled souls ended the last half of 2007 scrambling to raise equity. This mad dash was an attempt to patch the holes left as debt soured and the once-resilient market for CDOs and mortgage-backed securities skidded to a halt.
In the final six months of 2007, an article in the Financial Times reported that big banks -- from super-centers such as Citigroup (NYSE: C ) to investment banks such as Morgan Stanley (NYSE: MS ) and Bear Stearns (NYSE: BSC ) -- raised more than $83 billion in equity by selling shares in their own companies. This strategy brought desperately needed cash onto their books, albeit at the cost of diluting existing shareholders' stakes.
While $83 billion might not seem like a tremendous amount in a world where banks like Bank of America (NYSE: BAC ) are home to asset values in the trillions of dollars, the number equals more than the total amount of equity raised in all of 2005. And on top of that, more than $40 billion of outside money was injected into financial institutions from foreign friends around the globe.
The cost of help
While the newfound cash is certainly a welcome gift that is keeping banks heads' above water, don't get too comfortable with the benefits that come from issuing new equity. As these banks open their coffers and dole out gobs of new shares to investors, the per-share value of everything from book value to future earnings is whittled away, sometimes in staggering amounts.
Take the recent $7.5 billion injection Citigroup was awarded by the government of Abu Dhabi, in the form of convertible bonds that will be converted into stock. When the debt does convert to stock, which should happen in the next two to three years, investors will take an immediate 5% dilutive cut on their share of the bank's bounty. That's not to mention that if the current dividend stays intact, the additional shares will tack on more than $500 million per year in additional dividends needed to cover the newly issued shares. That doesn't include the $825 million in interest that will be shelled out per year until the shares are converted. Geesh. Seems an awfully high price to pay to patch up a rocky balance sheet.
Or take mortgage giant Countrywide Financial (NYSE: CFC ) . Back in August, when Bank of America came running with a $2 billion capital infusion to help the battered company stay afloat, investors cheered the news by sending shares up nearly 20%. Sure, bringing in a large partner like Bank of America may well be a saving grace for Countrywide. But, by doing so, investors surrendered as much as 17% of their existing ownership -- and none of that includes the possibility of future capital infusions that might be necessary.
Sweet timing, buddy
Having to issue equity through share sales is particularly painful now. When shares must be sold at low prices, more new shares must be issued to raise the desired amount of money. Countrywide's deal with Bank of America, for example, allows B of A to convert its investment into equity at $18 per share, or a full 60% below its 52-week high. Had equity been sold at the 52-week-high price, the dilution would have cost investors no more than 7.5%.
Bottom line: Even if these financial companies can battle their way back to the prosperous days of gushing profits, so much equity has been eroded and diluted from investors' pockets that even getting profits back to par (a prospect that seems slim right now) would still mean substantial hits. That said, it could indeed be many, many years before we see share prices return to their previous highs.
Taking financial stocks into your portfolio in 2008 certainly requires a healthy dose of homework. When attempting to place a future value on this battered sector, it's increasingly important to account for the dilutive effects issuing additional equity has on your investments.
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