If anyone wants empirical proof of the concept Zero Hedge brought up two weeks ago that the "creeping equitiziation" higher and higher into the capital structure of the sick banks is becoming a major issue for existing bondholders, one just needs to look at the price of Citi 7.25% Sub Notes due October 2010 (70) and Bank of America's 7.4% Senior Sub Debt due January 2011 (85).
Why is this chart relevant. David Darst at FTN puts it best:
"The current prices imply that the companies’ equity is worthless, the government’s investment is worthless and subordinated debt holders will lose some of their investment."
Additionally, the security tranche just below the sub notes, the Trust-Preferred Shares, is trading at less than 30 cents and yielding more than 25%. Zero Hedge has discussed the implications of pricing at various levels of the capital structure previously, but in summary as Citi sub bondholders are expecting roughly 70 cents on the dollar recoveries (at least based on the market action), there is, mathematically, zero value left over for any securities below this tranche, which of course includes both the TRUPS and the common stock. In practice this is not exactly the case due to optionality and hedging, but it does serve as a rough estimate of what the value of both Citi and BAC common stock should be.
There is, of course, an opposing view. Tim Band of Barclays had this to say: "The sell-off in senior bank debt is completely baseless [and prices]are reacting to “inchoate, illogical and poorly reasoned fear of political risk. Prices are cheap creating an opportunity to lock in attractive yields on senior bank debt that has been made more creditworthy than a few weeks ago because of the added government support." Then again, Tim's assumption is based that taxpayer cash will be used to fund asset shortfalls at Citi and BAC, which is not what occurred last time Citi was bailed out. It is ZH's belief that the latest model of forced equitization into common stock with no new capital will be the de facto model to be used by the government going forward, which means that more and more of the lower tier securities will end up getting massively haircut as they get converted into increasingly more diluted common stock.
Since most bank debt is held by insurers and foreign investors, and only a small portfio is owned by mutual funds, the negotiations with these bondholders will be very politically charged but the end outcome will likely still be the same, with the likes of sovereign wealth funds and insurance companies facing significantly more pain in the coming months. Ironically, as bond losses drive the cost of capital higher, the banks will be forced to ensure they don't do the same kind of "sloppy" underwriting that set off the credit crisis, according to Thomas Atteberry of First Pacific Advisors, and may be the reason why banks are so unwilling to lend even to legitimate borrowers as they see the writing on the wall. Atteberry, who is a believer in the tenets of capitalism, concludes "investors who choose to lend money to banks like Citigroup, which is poorly run, should share the pain of a business that’s having to write things off."
But at least Vikram is there to assure the market that all is good with the occassional one page memo now and then.
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