New Treasury’s Shackled Dividend Policy
Government is treating the country to a national conversation on corporate finance, focusing on a tension between common stockholders of corporations and those who lend or buy preferred stock. The government is deep into the business of lending or buying preferred stock with taxpayer money; the public is interested to know how secure those positions are and how likely they are to reinvigorate private investment in public companies.
While the Bush Administration made loans and bought preferred stock without insisting on many restrictions, the Obama Administration proposes a more restrictive posture. Both struggle with the inherent tension in corporate finance between protecting creditor and senior equity interests, on the one hand, and providing common (junior) stockholders with periodic returns on investment through dividends on the other.
Creditors and senior equity holders want assurance of repayment, so the temptation may be to prohibit common stock dividends entirely. This temptation explains why many populist critics rebuked Bush Treasury Secretary, Henry Paulson, for lending or investing in corporations without restricting their right to pay cash dividends to common stockholders. The rebuke may also explain Obama Treasury Secretary Timothy Geithner’s opposite proposal to prohibit such dividends, although this populist stance may prolong rather than shorten the current capital crisis.
In Paulson’s deals, people thought they saw a massive wealth transfer from taxpayers to common stockholders. For example, in the fourth quarter of 2008, many banks enjoying taxpayer-financed capital investment paid large dividends to common stockholders (although many in amounts lower than those paid in previous quarters). As examples: (1) Bank of New York Mellon received $3 billion of taxpayer capital and paid a $275 million dividend to common stockholders; (2) Sun Trust got $3.5 billion and paid a $188 million dividend (down from $272 million); and (3) Zions Bancorp got $1.4 billion and paid a $34 million dividend (down from $45 million).
But this wealth-transfer criticism may rest on some fundamental misapprehensions. Prohibiting cash distributions to common stockholders can deter investors from making or retaining investments in the common stock. Common stockholders appreciate a steady dividend policy. They may come to rely upon regular quarterly dividends, even to expect regular increases in the amount from year to year. In difficult financial markets, such as those prevailing today, at least the prospect of such a periodic return may be essential to induce sustained or new investment in common stock. And one purpose of government capital investment is to make that inducement.
Yet Secretary Geithner appears to have embraced the populist call, announcing on Tuesday that loans or investments his Treasury makes in corporations will come with prohibitions on their right to pay cash dividends to common stockholders. While certainly appealing to some populist sensibilities, this stance may backfire. After all, if one goal of government investment is to induce private investment in these institutions, a no-dividend policy is not likely a good way to get there.
True, if 100% of taxpayer investments were immediately distributed to the common stockholders, the result would be a one-for-one wealth transfer. But the distributions that have been made are a small fraction of that. Recipients that use the excess in their ordinary operations, like banks using the funds to lend to customers, seek to generate profits as a result, meaning returns on capital that will likewise reinvigorate private investor willingness to buy and hold their common stock. Only through some process like that will the enterprises rebuild capital strength to enable returning taxpayer funds to the public fisc.
The government is allocating taxpayer funds this way solely as a temporary exercise. It will be temporary only if it succeeds in restoring investor willingness to provide capital themselves. It is possible, and may be necessary, to improve weakened corporate capital positions by simultaneous government investment and distributions to common stockholders.
No doubt, Secretary Geithner understands all this. It is possible that his announced policy is designed as a pitch to appease public criticism of a perceived wealth transfer from taxpayers to stockholders. Certainly in his announced policy he expressly reserves the right to make exceptions to the dividend prohibition. But the Treasury Secretary must appeal to investors to make this investment program work. They need to hear that there is some prospect of return on capital ahead for them.