Countrywide (NYSE: CFC ) would be toast without Bank of America (NYSE: BAC ) . Bear Stearns is all but forgotten. Don't even get me started on Washington Mutual (NYSE: WM ) .
All this chaos puts a lot of strain on CEOs to ensure that their establishments aren't next on the chopping block. Among the toughest questions facing executives now, one in particular stands out: "Should we continue our dividend, even though we're scrambling for cash as it is?"
An article in last week's Wall Street Journal titled "Dividend Dummies?" put that question on the line. While raising some good points, author Holman W. Jenkins, Jr. sidesteps a few factors with which CEOs have had to grapple when debating what to do with the dividend.
Jenkins' thesis -- that we shouldn't jump to conclusions and assume CEOs are all a bunch of nutjobs for paying a dividend while scrambling for cash -- makes sense. But I don't agree with the way he reached that conclusion.
Is all cash good cash?
Here's how Jenkins put it:
Money is money. Whether a company retains its earnings or pays them out, shareholders are still the beneficiaries of its cash, and shareholders are not so dumb they can't figure this out. They are not so dumb, in other words, as to prefer receiving a dividend if it would be more advantageous for their company to deploy its cash elsewhere.
I beg to differ. No offense, but as a group, shareholders are a gullible bunch. A mere whisper of weakness is enough to cause investors and counterparties to fold. Shoot now, ask questions later. Bear Stearns and JPMorgan Chase (NYSE: JPM ) know this all too well. Lehman Brothers (NYSE: LEH ) isn't too far behind. That said, of course it's worthwhile for banks like Citigroup (NYSE: C ) to keep the dividend pumping. It's one of the only ways you can appease skittish investors who question whether there's enough money to keep the lights on!
But never mind that. Let's assume the cost of capital is the end-all of dividend decisions. Where would that leave a bank like Citigroup? As Jenkins wrote: "Would it have been more advantageous to shareholders to curtail the dividend (as, in fact, Citi partly did) than seek outside money? That depends partly on the terms."
Fair enough. So let's look at the terms. Back in November, Citigroup raised $7.5 billion from the Abu Dhabi Investment Authority. The units pay an initial 11% interest rate, and are convertible to stock in the next two or three years, which would be dilutive to existing shareholders.
$7.5 billion is close to what Citi is paying out each year in dividends. By raising new capital, Citi got $7.5 billion at a cost of $825 million per year, plus the possibility of diluting shares by what was around 5% at the time the debt was issued. Its current dividend yield is around 5.8%. As a long-term investor, which would you rather take?
Had Citi, back in November, thrown up its arms and said "Enough. No more dividends until we get back on track," it could have retained the same $7.5 billion (over the course of about a year) and forgone the impending share dilution. And don't kid yourself; share dilutions of a few percentage points are nothing to sneeze at. They can make a hefty difference over the course of many years when the power of compounding takes hold. Mind you, this was only one round of a $40 billion (and counting) capital-raising campaign.
Not this time
Raising capital with convertible preferred shares paying 11% interest isn't small change. To put it in perspective, the PIMCO High Income Fund (NYSE: PHK ) -- essentially a junk bond fund -- yields around the same 11%. If the new capital weren't convertible into equity down the road, the yield would likely have been even higher than the 11% to which Abu Dhabi agreed.
Had Citi been able to raise money at a significantly lower rate, the story would be far different. Jenkins addresses this -- to a point:
Whether banks are wiser to replenish their depleted capital by retaining income now used to pay dividends, or wiser to raise the capital from outside and keep paying the dividend, depends on which is a cheaper source of capital.
Bingo! But the cost of Citi's new capital isn't potatoes, as we've seen. In fact, it's ... all right, enough twaddle. In layman's terms, Citi's paying existing investors with money from new investors at an unsustainable rate. Few seem to mind that a similar technique was popularized in the 1920s by a man named Charles Ponzi. As long as the money's still coming in, few ask where it's coming from.
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