Citibank Dilutes the existing Shareholder stakes

Abu Dhabi Investment Authority said it will invest $7.5 billion in Citigroup Inc. Once the equity units Abu Dhabi bought are converted into stock in 2010 and 2011, Abu Dhabi will hold a 4.9 percent stake in Citi. Until those units get converted, Citi will pay Abu Dhabi a yield, or essentially an interest rate, of 11 percent. This is a hefty interest rate and also the analysts estimate earnings per share going forward will be diluted by about 3 to 4 percent by the sale. A very bad move for the investors more like the scenario 3 below.


What does all this mean to an average investor named Joe?


Stock dilution refers to when a company issues additional stock, for any purpose. Some of those purposes are bad for outside shareholders, some are neutral, and believe it or not, some are actually good. We examine all three scenarios to see how they can affect us as investors.

Example.
In 2005, Phaser(a hypothetical company) had 100,000 shares of common stock outstanding, a market cap of $1 million, and $100 of net profits.An individual investor Joe, on Dec. 31, 2006, bought 10,000 shares of Phaser stock. When the company reported its earnings, Joe was elated to learn that, by virtue of his stake, he vicariously earned $10 worth of Phaser's profits. Little did he know what 2007 held in store for him.


Dilution Scenario One
In 2007, Phaser decides to engage in the worst of the three main ways that companies dilute their shares: It issues 100,000 stock options to its CEO. For the time being, Phaser has a "basic share count" of 100,000 shares actually outstanding. But because its CEO will eventually exercise his or her stock options (i.e., tell the company to issue 100,000 shares to him or her and then sell them on the open market), Phaser now has a hypothetical, or "diluted," share count of 200,000.

That's bad news for Joe. While he will still own his 10,000 shares, his ownership stake will be diluted once the company issues that extra stock. What does that mean? Well, when Phaser's share count stood at 100,000, and it earned $100, Joe was entitled to 10% (10,000/100,000) worth of those profits, or $10.

But when Phaser issues those 100,000 extra shares, Joe's shares will not equal 10% but just 5% (10,000/200,000) of all shares outstanding. If Phaser earns $100 again the next year, Joe's take from that haul is just $5. Poor Joe.

The CEO, on the other hand, gets 100,000/200,000 worth of the profits, or $50. Lucky CEO!

Thus, the primary reason Fools dislike stock dilution is that it often represents a transfer of wealth from outside shareholders -- you and me -- to insiders.


Dilution Scenario Two
Stock dilution, however, isn't always bad. But before we look at when it can be good, let's consider the iffy situation of a company that acquires another one and pays for the purchase in stock. Say Phaser wants to expand its business. Phaser's solution is to buy out a rival.Since Phaser hasn't sold anything and doesn't have any actual, er, cash, it wants to issue its own stock to target company shareholders in exchange for their shares.

Now, if the target company has a market cap of roughly $32 billion. With Phaser shares trading for $10 a stub, our intrepid company will have to issue 3.2 billion new shares to acquire its heart's desire. Doing that will dilute Joe and Phaser's other shareholders thousands of times over. In what universe could that much dilution possibly be a good deal for Phaser shareholders?


The answer requires another question: Is Phaser overpaying for its purchase? If Phaser pays a price equal to target company's intrinsic value as a business, then the dilution created by the purchase does not really hurt Joe. Yes, Joe's slice of the merged Phaser pie looks much smaller than his slice of Phaser alone does. But the new pie is much bigger. Picture this: Joe is receiving a much thinner but also much longer slice of the (Phaser+Target) pie, in return for his original wide but stubby slice of Phaser.

And there's another possibility to consider. Alone, Phaser may not be objectively "worth" the $1 million market cap that the market accords it. If Phaser's stock is overvalued, then paying for an acquisition in inflated-value stock may be a smarter move than paying in cash.


Issuing More Stock through public offering or Convertible Bonds
When Phaser gives 100,000 shares to its CEO for a nominal "exercise" price, that's bad for outside shareholders. But what if, before Phaser decides to go that route, the message-board rumor mill gets going and anoints Phaser as the next moon-rocket stock? As Phaser's stock price doubles, triples, and then jumps 10 times more, company management reconsiders, decides not to issue options, and instead sells the 100,000 shares on the open market -- at $600 a pop.

If the company's intrinsic value hasn't changed, and if only its stock price has increased, then this is great news for Joe. After the secondary offering is completed, he again owns 10,000 shares out of 200,000, or 5% -- down from his original 10%. However, Phaser itself is now worth more -- not just from the rumor-bubble pricing of its stock but also intrinsically, because the company has traded 100,000 shares for $60 million in cash. That cash now sits in the company's bank account, and Joe owns 5% of it, or $3 million.

So to sum up, whenever a company issues shares at a price higher than the shares' intrinsic value -- whether it does so to buy another company or to sell the shares and raise cash on the market -- an outside shareholder benefits, despite his or her percentage of ownership being diluted.

The above article is courtesy MF

Living in a Southern California Bubble

24 Shady Lane, Irvine, CA 92603, was purchased in January 2005 for $1,157,000. The combined first and second mortgages totalled $1,156,730 leaving a downpayment of $270.

By April 2007, they had multiple refinances on it finally with a first mortgage for $999,999, and a HELOC for $491,000. These owners pulled $333,000 in HELOC money.

Assuming they spent the entire HELOC, and assuming the negative amortization on the first mortgage has increased the loan balance, the total debt on the property exceeds $1,500,000. The asking price of $1,249,000 does not look like a rollback, but if the property actually sells at this price, the lender on the HELOC will lose over $300,000.

This is the story of a lot of households in California.

The Winner - The owners (may be...)
The Loser - The bank (lack of due diligence and loan standards)

This information is courtesy IHB

What are SIVs?

Background...
SIV (Structured Investment Vehicle) has high net worth investors like hedge funds or wealthy individuals who invest say $1 Billion in the SIV (the equity). Then the SIV issues commercial paper (CP) and medium-term notes (MTN) that pay slightly higher rates than similar duration paper. The typical SIV, according to Fitch, uses 14 times leverage, so in our example the SIV would sell CP and MTN for $14 Billion.

Now the SIV invests this $15 Billion ($1 Billion equity and $14 Billion borrowed) in longer term notes. The idea is simple: borrow short, lend long, hedge the interest rate and credit risks - and the profits flow to the investors in the SIV.

Usually the bank sets up the SIV, attracts the investors, manages the SIV for a fee - and there was always the appearance that the SIV CP was backed by the bank - perhaps allowing the CP and MTN to pay lower interest rates.


Now the problem....and how HSBC plans to solve it

Some SIVs invested in asset backed paper, backed by home mortgages. Even though the SIVs almost always invested in the highest tranches (with no losses to date), the market value of these assets has fallen recently.This means that the investors in the SIV (the equity) have taken paper losses on their $1 Billion investment.In fact many of the SIV NAVs have fallen substantially.A NAV of 71% means the $1 Billion equity in the example is now worth $710 million.


Once the value of the equity falls enough (usually 50%) there is usually a trigger event forcing the SIV to liquidate the longer term investments. A forced liquidation might not only wipe out all the remaining SIV equity, but the holders of the CP and MTN might take some losses too.


This has made potential investors in CP and MTN (not to be confused with the investors in the equity of the SIV) to refuse to buy any more CP. Since there is a duration mismatch - the investments are in longer term notes, CP is less than 9 months - the SIV is stuck with a liquidity problem when the CP comes due.


To solve this problem, a bank like HSBC could explicity guarantee the CP and MTN, and this would attract investors in CP and MTN again. But under accounting rules, this guarantee means the SIV belongs on the bank's balance sheet. The structure stays the same - the SIV equity investors still take the losses - but there is no liquidation event. If the losses exceed the equity investment ($1 Billion in our example), then the bank would start taking losses.

The balance sheet lists the assets and liabilities of the company. Moving the SIV to the balance sheet simply means adding the $15 Billion in assets (those longer term notes) to the Asset portion of the balance sheet, and moving the $15 Billion in CP, MTN and SIV equity to Liabilities. The new assets balance with the new liabilities, and there is no income or loss for the bank. Since the equity will take the losses first, any mark down in the $15 Billion in assets will be matched by a mark down in the liabilities - up to $1 Billion.

Problem for the bank?
There is an impact on the ratios of the bank - the reason the SIVs were off the balance sheet in the first place - and this limits other lending activities of the bank, contributing to the credit contraction.

The above information is Courtesy CR

Is this a confirmation to Sell?

Maybe.....


1. DJIA and DJTA must undergo a significant correction from joint new highs.(July 2007)

2. In their subsequent rally attempt following that correction, either one or both of the averages fail to rise above their precorrection highs. (Sep 2007)

3. Both averages must then drop below their respective correction lows. (Nov 2007)

For those who care, 12,846 is the number to watch..........