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An Open Letter to Publicly Held Bank CEOs, Boards, and Shareholders:

2007 has certainly been a trying time for banks. Many of the business lines which had generated large fees in recent years, such as subprime lending, structured investment vehicles, private equity bridge loans, collateralized debt obligations, etc., have resulted in banks suffering large losses.

There are many questions now being asked by bank shareholders. Where were the risk controls? Should banks have seen subprime problems coming? How did banks become so sanguine about ever increasing leverage? These are fair and important questions. But the key question for bank shareholders looking forward is how to best position for profit growth in the future.

Unfortunately, with banks suffering such large losses in recent quarters, bank capital has come under pressure. Bank liquidity overall has diminished. Many bank assets which previously could have been securitized to raise capital if needed, would now either be impossible or costly to liquidate.

Despite all the problems banks are currently facing, we know the U.S. economy is amazingly dynamic. We know that at some point in the future, demand for fee generating bank products will rebound. Even subprime lending will likely be an attractive business again at some point in the future. Many marginal banks and/or other providers of capital, have exited the market. Some due to bankruptcy and others by choice. This leaves the surviving banks with better pricing power and/or ability to dictate lending terms. Overall, the long-term prospects for banks should be quite positive.

However, in order to realize this long-term opportunities, banks must find a way to survive the current contagion with as much capital preserved as possible. Long-term shareholders appreciate this need for capital preservation. It would not serve shareholders interests to sell assets at fire-sale levels to raise capital. Nor would shareholders benefit from a bank being forced to issue new equity shares, particularly at a time when equity prices are weak.

There is one obvious way for banks to retain more capital: eliminate the dividend. Large publicly traded banks all pay handsome dividends. In many cases, the dividend is a sizable percentage of the bank's regulatory capital, and retention of the dividend could make a significant difference in the bank's liquidity in a time when liquidity is dear.

Of course, bank CEOs are loathe to cut their dividend as this would likely cause their stock to decline. But if the bank were operated with long-term profits as their goal, much like a private company is run, a temporary suspension of the dividend would be an obvious choice. Investors in a private company would never choose a small cash payout at the expense of much greater long-term profit potential.

What if a major bank CEO were to announce to shareholders that dividends for the next 4 quarters would be suspended, but not eliminated? The bank could pledge to pay out the missed dividend payments at the end of the 4th quarter if the liquidity situation has improved.

Of course, the first bank to make this move would likely scare the market into thinking the bank had an imminent cash crunch. But if the bank was able to prove that this was indeed not the case, and that accruing the next year's worth of dividends was merely the best way to manage regulatory capital, the market for the bank's shares would improve. Indeed, I am confident that the bank that shows a willingness to use all possible avenues to retain capital will eventually be rewarded with a stronger stock price.

Would any bank CEO be willing to withstand the avalanche of criticism this move would entail? Particularly those who may already be under pressure because of recent losses? Difficult to say. But if any bank continues to pay its dividend and later finds themselves in a capital crunch, it will be clear that its CEO was trying to manage with a short-term and not a long-term horizon.

Shareholders should start demanding banks explain their capital preservation strategy now, particularly if the bank insists on maintaining its dividend. Perhaps this will give some CEOs the flexibility to use their dividend policy in a way which maximizes long-term profits.

Sincerely:

Accrued Interest