The idea of the “zombie bank” has become rather ubiquitous since 2008 and in a landscape characterized by both multi-billion dollar legal settlements stemming from crisis-era malfeasance (the public utility vs. bankruptcy trade-off) and hopelessly depressed NIM thanks to artificially suppressed rates, we’re not surprised that a bit of creativity is required to keep both regulators and shareholders pacified. As Reuters notes, one preferred (pardon the pun) route for banks of late has been a simple version of left-to-right pocket accounting:
Big U.S. banks, including JPMorgan Chase & Co (JPM.N) and Citigroup Inc(C.N), are expected to win Federal Reserve backing on Wednesday to buy back more shares and increase their dividends in the coming year, but the approvals may be as much about the institutions’ financial engineering as any improvement in their health.
Much of the money for buybacks and higher dividends is coming from the banks issuing securities known as preferred shares. These shares are a type of equity that pays regular, relatively high dividends. To investors they look a lot like bonds that pay interest. But for regulators, preferred shares serve as a cushion against any future losses, in part because they never have to be repaid.
Critics of the strategy question how sustainable it is, as banks essentially take money from one set of investors and give it to another, and at an added cost.
Issuing preferred shares to pay for common share dividends and buybacks is a symptom of a "zombie banking system," said veteran banking analyst David Hendler of independent research firm Viola Risk Advisors.
"Banks should be building capital from normal lending and trading profits," he added.
Yes, they probably should, but as we noted above, generating income from “normal lending” is a bit difficult given ZIRP-squeezed margins and with Volcker, the government is effectively looking to cut-off one of Wall Street’s most lucrative businesses, so what’s a TBTF firm to do? One solution is to take advantage of investors’ epic hunt for yield by simply issuing preferreds which has the dual benefit of shoring up capital cushions while simultaneously funding buybacks and dividends — even if it's fairly costly.
Here’s Reuters again:
Citigroup, for example, issued $3.7 billion of preferred shares in 2014 and has publicly disclosed plans to issue $4 billion of preferred shares this year and another $4 billion to $6 billion before 2019.
Veteran bank analyst Mike Mayo, who is at brokerage CLSA, estimates that the bank will ask to return roughly $7 billion of extra capital annually to shareholders in the coming year. “The preferred gives them an extra cushion” over minimum capital requirements to make the payouts, Mayo said.
Selling preferred shares to boost payouts to common shareholders can't go on forever without banks improving their results enough to boost their capital levels significantly.
Mayo expects that next year Citigroup will come up with additional excess capital from a planned sale of assets, including its OneMain personal lending unit.
JPMorgan issued nearly $9 billion of preferred shares this past year and other banks have said they expect to issue more. JPMorgan said in February that the sales will go toward satisfying pending requirements that big banks have enough capital to absorb losses in a financial crisis.
At least we know that Citi’s sale of OneMain to Springleaf will serve to make the bank better capitalized even as it creates a giant subprime consumer loan securitization machine. Perhaps the best part about the whole thing however is this:
Declared dividends for all of JPMorgan's preferreds amounted to $1.1 billion in 2014, compared with $6.1 billion in common dividends. For common shareholders, the preferred dividends were subtracted from the company's reported net income, leaving $20.6 billion for common equity and reducing earnings per share by about 30 cents, or 5 percent. That in itself can hold back a bank's share price.
That may be true, but as long as banks can offset the hit to their bottom line occasioned by paying preferred dividends by using cash from selling preferred shares to buy back common, all is well. What a truly virtuous circle.