Tokyo-based Sumitomo Mitsui Financial Group Inc. (SMFG) recently announced that it will buyback its preferred share capital worth about $1.1 billion from Goldman Sachs Group Inc. (GS) to convert into common stock. SMFG has offered the conversion to Goldman Sachs in the wake of its $9.6 billion capital raising strategy, as it plans to use the proceeds to purchase preferred and other debt securities in order to diminish interest expense of the company.
 
Sumitomo Mitsui, the second largest Japanese bank, aims to raise capital worth $9.6 billion by issuing shares of its common stock before more stringent international capital regulations come into play. According to the capital requirement being formulated, a company’s Core Tier 1 capital should include only the sum of common shares and internal reserves but not its preferred securities or preferred shares. Hence, SMFG is asking Goldman Sachs to convert its preferred securities in SMFG to common stock.
 
To achieve this, SMFG will issue 340 million common shares, 180 million of which are earmarked for overseas investors, representing about 36% of the bank’s outstanding stock. The offering price is expected to be laid down between Jan 20 and Jan 22, 2010. However, these preferred securities (a hybrid of debt and equity) have earned high dividends for Goldman Sachs and this buyback could leave Goldman Sachs without any equity in SMFG.
 
Goldman Sachs has a 24-year old relationship with SMFG, when the Japanese company invested $500 million for a 12.5% stake in the US firm in 1986. When SMFG in turn was short of cash in 2003, Goldman Sachs bought 150.3 billion yen of SMFG preferred shares, paying an annual dividend of 4.5% to help boost capital that deteriorated by losses on stockholdings and bad loans. In April 2008, Goldman Sachs converted a third of these securities into common stock.
 
Goldman Sachs International, Citigroup Global Markets Holdings Inc., a division of Citigroup Inc. (C) and Barclays PLC (BCS) will be the joint underwriters of SMFG’s share issuance. SMFG also intends to issue as many as 20 million additional shares, underwritten by Daiwa Securities Capital Markets, in case a strong demand is perceived.
 
The Goldman and SMFG tie-up also inspired Morgan Stanley‘s (MS) decision to sell a stake to Mitsubishi UFJ Financial Group Inc. (MTU) to raise capital during the peak of the financial crisis in 2008. As part of the agreement, Morgan Stanley and Mitsubishi UFJ also agreed to pool resources for deals in the US.
 
The potential capital rising course in SMFG is crucial for the company to replenish its starved balance sheet, post the dramatic downturn that affected most of the Japanese banks including Mitsubishi UFJ and Mizuho Financial Group Inc. (MFG). While, the proceeds from the share issue will help SMFG to bolster its capital leverage, reduce loan and debt accounts as well as the interest costs thereon, the conversion of Goldman’s shares alongside will help the company in relaxing its hedge positions, a significant move to reduce risk in the current volatile economic scenario.
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