Government Intervention in the financial system is bad for shareholders

Over the weekend the British government announced that it was increasing its stake in UK bank Lloyds TSB (LYG) to 65% and possibly 77% in return for insuring over 367 billion dollars in toxic assets. The government will do that by converting some of its preferred shares in the bank into common. As part of the agreement, the bank will take a "first loss" of up to 25 billion pounds, with the U.K. government shouldering 90% of any subsequent loss.

Lloyds was one of the most conservative lenders in the UK which didn’t have as much exposure to toxic assets until it acquired troubled bank HBOS back in September 2008. The way events unfolded back in September and October when banks worldwide were acquired shows that virtually no due diligence was made given the tight deadlines for the deals to materialize.

Eighty percent of the toxic assets came from HBOS, which Lloyds agreed to buy in a government-brokered deal in September 2008. HBOS reported $14 billion of loan losses last year, up fivefold from 2007.

Because of the losses from HBOS acquisition, Lloyds has been forced to seek asset protection program. While the stability of the banking system might be ensured with this deal, shareholders of any banks are being diluted across the board. Even banks that didn’t take excessive risks during the boom years are suffering, as they are merging with competitors who held the majority of bad assets. This leads the acquirers to seek government assistance and cut dividends to maintain liquidity. This hits shareholders two folds – first their ownership is diluted and second their dividends are cut or eliminated.

A similar picture is being painted in the US as well, as the government recently converted a large portion of its preferred stock into common at Citigroup (C), raising its stake to 36% of the company by converting $25 billion in TARP emergency aid into commons shares.

Bank of America (BAC) might be largest casualty of the mortgage crisis. It completed its purchase of troubled mortgage company Country Wide Financial for $4.1 billion in July 2008. BAC also bought Merrill Lynch for a $50 billion in BAC stock. The bailout of Merrill Lynch was needed, as the company had an operating loss of $21.5 billion for the last quarter of 2008. Bank of America also disclosed it tried to abandon the deal in December after the extent of Merrill's trading losses surfaced, but was compelled to complete the merger by the U.S. government. Bank of America received $20 billion from the US government through the TARP program in addition to a guaranee of $118 billion in potential losses in January. That was in addition to the first $25 billion dollars that the bank received through the Troubled Assets Relief Program back in October 2008. In the meantime Bank of America (BAC) has cut its dividend twice. Our blog warned readers that BAC’s dividend was not well covered back in July 2008. We also warned about the second dividend cut in January as well.

Other banks, which might have been forced, into buying troubled companies include Wells Fargo (WFC), which acquired Wachovia (WB) several months ago. As a result Wells Fargo (WFC) took on $25 billion from TARP and reduced its dividend by 88% in an effort to maintain liquidity.

JP Morgan Chase (JPM) acquired troubled investment bank Bear Stearns backing June. Bear was one of the first victims of the sub-prime fiasco. Its problem two funds in the summer of 2007 were some of the first triggers that send shockwaves to markets worldwide, signaling he start of the bear market. In October 2008 JPM also took $25 billion in preferred stock from the treasury. Most recently it cut its quarterly dividend by 87%, from $0.38 to $0.05. Chief Executive Jamie Dimon said the cut was a precaution to ensure that the company has financial flexibility if economic conditions worsen. The move will save the company about $5 billion annually.

Shareholders who are still holding on to Bank of America, Wells Fargo and JP Morgan stock and hoping that once the crisis is over these stocks would go up, should be very careful in their analysis. If the US government initiated the next step in the TARP program and starts increasing its stakes in major US financial institutions this would dilute existing shareholders equity. In this situation $1 would be the upside target for most shares of US financial institutions.

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Relevant Articles:

- TARP is bad for dividend investors
- Bank of America (BAC) Dividend Analysis
- Bank of America (BAC) might have to cut dividends again
- Wells Fargo Joins the Crowd of Dividend Cutters