Bennet Sedacca is asking Who Will Be Next Bear Stearns?

Without naming names quite yet, what would you think of a company that accomplished the following in 2007?

  • Wrote down book value from $39 billion to $32 billion or from $41.35 to $29.34 per share.
  • Increased shares outstanding from 868 million to 939 million.
  • Increased Treasury Stock from 351 million to 418 million.
  • Increased long-term borrowings from $147 billion to $201 billion.
  • Increased preferred stock issuance from $3.1 to $4.4 billion.
  • Increased Total debt to common equity to 2816.81%.

I could cite 20 or more similar financial ratios and they are all stunning.
Who is this firm? Merrill Lynch (MER)

Some statistics on another potential bad bank:

  • Wrote down book value from $35 billion to $31 billion or from $32.67 per share to $28.56 per share.
  • Increased long term borrowings from $127 billion to $160 billion.
  • Increased total debt to common equity to 2496.53%.
  • Maintains an $88 billion position in Level 3 assets, or 283% percent of shareholder equity.

Who is this firm? Morgan Stanley (MS)

There are only two solutions in my mind for what can happen to these firms. They can raise capital or sell themselves, perhaps for not very much.

The capital raises I foresee in the second quarter might be something for the record books. Fannie Mae (FNM) and Freddie Mac (FRE) may need to raise up to $20 billion this year through a combination of preferred, convertible preferred stock and equity to get their financial ratios into OFHEO compliance, as they are being asked to pick up the slack of the hundreds of mortgage lenders that have gone bad and the commercial banks that are now backing away from lending. I just read a news story where UBS (UBS) may need to raise upwards of $16 billion. Merrill, BankAmerica (BAC), Wachovia (WB), Morgan Stanley, HSBC (owner of Household Finance), and many others will not be far behind.

How long will market participants be available to buy all of this new paper? My general take is not for long.

Ouch! That’s My ARS!

About a month back, I wrote an article entitled Pain in the ARS. ARS, or Auction Rate Securities are now beginning to make headlines and could prove extremely damaging to investors and the dealers that sold them to investors.

The securities yield a bit more than traditional money market funds and were considered “cash equivalents” when in reality they are very long term bonds that reset every so often, so long as there is a buyer and the auction doesn’t “fail” to attract enough buyers to reset the rate. What happens in a failed auction? The owner cannot get their money back from the brokerage firm—they simply have to stick it out until enough buyers are found to avoid failure.

When brokerage firms were flush with cash and making lots of money from traditional activities like investment banking, auctions never failed. The dealer simply stepped up and bought the remaining ARS and kept the auction from failing. These days, however, the dealers, like UBS (UBS), Merrill and Morgan Stanley are in dire need of capital themselves, leaving the investor to hold the security, perhaps for the entire duration, or 40 years.

This brings to light several important points. First, you are stuck in the security for possibly a long time, but failed auctions pay investors the “maximum rate” as defined by the prospectus, which on the surface sounds good. But in reality, most of the shares associated with closed end bond funds have a maximum rate of 110% of commercial paper.

Blackrock Muni Insured Floating Rate History

Blackrock Muni Insured Maturity Data

Note the “workout date” of 12/31/49. That is 41.75 years for those counting. And with the commercial paper index plummeting along with Fed Funds, I fully expect commercial paper rates to settle as low as 2%, which would net the ARS holder a whopping 2.2% and no liquidity.

So what is happening? UBS announced on Friday that it’ll begin to mark the securities to market (as if there actually were a market). They haven’t yet disclosed their pricing methodology but I have one of my own. If someone asked me to buy this security, I would demand a yield of 10%. After all, I can buy agency preferred stock at 12% tax equivalent yield with loads of liquidity. Where would that bond trade? Yikes: something on the order of 23 cents on the dollar, as my table below shows.

Theoretical Price for a 2.2% ARS

There are actually some examples that are actually worse than this. Some student loan-backed ARS have reset to zero coupons. What would I pay for a forty year security with no yield? Zero.

The greedy are now being penalized. It’s now possible that the good, the bad, the not-so-good and the ugly will all get hurt at once. Such is the unwinding of greed.

The above is just a portion of Sedacca’s article, an article I consider a great read in entirety. Also covered in the article are ideas of how to play good banks, bad banks, and the in between banks. Those interested in income will welcome reading ideas on Fannie Mae and Freddie Mac debt.

How long the Fed can keep the train on the tracks remains to be seen but I agree with Sedacca that it might not be too long. Capital impairments are simply too high, and the combination of rising unemployment, imploding commercial real estate, and homeowners walking away will be too much for lenders to handle. One or more major banks and broker dealers in addition to Bear Stearns will not survive the coming train wreck.

Mike “Mish” Shedlock
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