Dilution? Yes. Ice? No.

Part 1.

As any connoisseur of Scotch whiskey knows, dilution of the spirit in question with a small amount of carefully chosen water does much to enhance the experience by opening up the whiskey and fully exposing the flavors and aromas to the taster.  Ice, by contrast, brings opacity rather than clarity.  It lowers the temperature, dilutes unpredictably, and effectively closes the whiskey to the taster.  More here.

Nationalization of the U.S. banking industry is the topic du jour in financial circles. The recent announcement of an increased equity stake in Citigroup by the U.S government is another step in that direction.  Amusingly, it came in the same week that Tim Geithner stated that nationalization was not being considered.  Although to be fair, Geithner said quite a bit in that interview.  So what to make of all this talk?  And what the heck does Scotch have to do with the financial system?

Well, nationalization in its purest form involves placing the institution in question into government receivership, wiping out the equity stakes of all of the shareholders and putting complete ownership in the hands of the government.  But there are many stops on the train to full nationalization.  The government can take a partial ownership stake of any given percentage which can, in turn, be increased or decreased over time.  There are also many forms of equity in a modern corporate capital structure, providing a myriad of mechanisms to bring fresh capital, new ownership and management control.  Finally, a regulatory regime, by effecting control, can even be seen as a form of ownership.  Oh no.  More complexity.

To distill the matter to its essence, however (and to return to the thematic whiskey metaphor while disembarking from the rather silly and tangential rail metaphor used in the prior paragraph), one can concentrate on the concept of ownership, or common stock if you prefer. Up to this point, the government has been using a combination of incremental controls, cheap loans (from the Fed) and ownership (via capital injections) to help the financial institutions.  This has had some effect, but it has not stabilized the system because of its inherent unpredictability.  Financial institutions rely on the views that others have of their solvency to be able to conduct business.  If you don’t trust the bank, you won’t give them your money.  If they don’t have any money, they can’t lend any.  Because of the way banks work, even the seemingly large amounts of capital being injected into them by the feds is peanuts if counterparties don’t think they’re predictably solvent.  Stay with me.

Now, solvency is about trust, and trust is a tricky thing to quantify.  How much do you trust [fill in the blank – husband, wife, boss, employee, weird-looking guy standing next to you on the train (oh no, there’s that silly train metaphor sneaking into the station)]?  One way to determine trust in a publicly-traded company is to look at the share price.  But the share price is going to be adversely affected by dilution.  If the price per share is $10 when there are 10 million shares total (just to pick a number), what happens to the price when the government swoops in and says it now owns half the company?  Well, instead of you owning 1 share out of 10 million, you now own 1 share out of 20 million.  The government owns half and everybody else has their remaining half.  Your ownership has been reduced by half, so your share is effectively worth $5 today rather than the $10 it was worth yesterday.

Thesis 1:  Unpredictable dilution (by incremental government action) means an unpredictable share price.  And an unpredictable share price takes away one method of determining whether you trust the financial institution.

Dilution is one thing, but ice?  As we say in the Cowboy’s favorite cantina: “No way, José.”

(to be continued)

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Published in: on February 27, 2009 at 22:54  Comments Off on Dilution? Yes. Ice? No.  
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