Saturday, April 4, 2009

Wall Street Back To Its Criminal Ways?

There was a time on Wall Street when insider trading was rampant, when sellside analysts would pump stocks under the guidance of their superiors only to have their corporate finance colleagues do an equity offer shortly after, when the amount of money a bank's corporate clients paid would determine its rating, and when analysts said in internal emails a company is worthless, only to issue reports claiming the company was the next sliced bread. Then things changed for the better briefly, when Spitzer came on the stage. However, with his thunderous fall from grace in an act of utter hypocrisy, the behavior he fought so hard to curb started gradually coming back.

Yesterday, Wall Street's shadiness came back with a vengeance.

As Zero Hedge disclosed yesterday, mall REIT Kimco decided to dilute its equityholders by issuing over $700 million (including the green shoe) in new shares which would be used to buy back the company's debt, as KIM has $735 million in debt maturities over the next 3 years, and a $707 million currently drawn on its secured credit facility. One look at the company's equity prospectus reveals that the lead underwriter is non other than "scandal-central" investment bank Merrill Lynch.


There is, of course, nothing wrong with being a member of an underwriting syndicate - in fact, absent generating profits from AIG structured finance liquidations forever, banks like ML (better known these days as Bank of America's slam dunk acquisition if one listens to Ken Lewis) will need it if they want to generate revenues. However, what Zero Hedge has a major problem with, is what ML equity research analyst Craig Schmidt did hours if not minutes after the offering was announced. In a research note update, Schmidt, who now gets his paycheck from Bank Of America (this will be relevant in a second), raised KIM's rating from Underperform to Buy.



This is where visions of Jack Grubman should resurface. While Zero Hedge will not speculate over the efficiency of the Chinese Wall at Merrill Lynch, aka Bank Of America, something in this transaction stinks to high heaven.

Let's walk through the sequence of events:

1) First Merrill Lynch/BofA gets clients to subscribe to a massively diluting equity offering (105 million new shares out of 271 million pre-offering shares, or 39% dilution). The offering prices at $7.10/share, a 6% discount to the previous day closing price of $7.49. In the process Merrill pockets an underwriting fee likely equal to 3% of the offering or around $20 million.

2) Minutes after the offering Merrill REIT analyst Schmidt comes out with a report, changing the recommendation on the stock from a Sell to a Buy, thereby getting the vanilla money which makes critical fiduciary decisions merely based on what some sell-side analyst will recommend. As a result Kimco stock rises throughout the day and closes at $9.40, a 25% premium to the closing price, and a 30% premium to offering price of $7.10, which closed that very same day.

3) Notable here is that Schmidt had come out with a Sell (aka Underperform) report on the company less than two months ago, on February 5, titled "Write-downs drove the miss." Among Schmidt's concerns were the following very salient points:
Write downs, not Q4 operating metrics, are the issue

KIM’s Q4 operating metrics took a back seat to write downs in the quarter as the company reported a sharp drop in FFO as it booked $111.8mn in non-cash impairment charges. These write-downs included $83.1mn for securities investments, $22.2mn for the equity investment in JVs with Prudential and $6.5mn for development projects in addition to $4mn of severance charges due to a reduction in headcount. While Kimco’s shopping center operations held up reasonably well in Q4 (rent spreads remained positive and same-store NOI was +1.4%), the company expects far weaker results in 2009 which is common theme running through the REIT industry.

Transaction income non-existent; lowering estimates

With the extensive write-downs, KIM’s reported 4Q08 FFO of $0.04 was $0.21 below our estimate. Looking to ’09, we expect NOI to decline 3% which includes a 300bp decline in vacancy by YE09. Given the impact of deteriorating operating metrics combined with a sharp reduction in transaction activity, we are reducing our ’09 FFO estimate from $2.15 to $1.74 while our ’10 estimate drops from $2.14 to $1.60.

Lowering PO to $12.50

Due to lower projected NOI growth for ‘09, we reduced our forward NAV for KIM from $17.04 to $14.13 and as a result our PO falls from $15.50 to $12.50 which is roughly a 10% discount to forward NAV. Given the weakness in retail spending and cautious leasing environment combined with a sharp erosion in Kimco’s noncore business segments we are maintaining our Underperform rating until we gain better visibility on the retail landscape.
4) Even assuming Merrill's Chinese Wall is fully operational, it would be curious to see how the company managed to "sell" to its clients a stock offering in which its very own analyst had a Sell rating: the cynics among us would presume these very clients would have no problem buying into the offering if they knew or anticipated a change in recommendation (especially one from a Sell to a Buy), and knew they could flip the stock they bought through the offering for a 30% gain in one day!

5) And now for the piece de resistance. The company said in its prospectus it would use the offering proceeds to pay down its revolver. "We intend to use the net proceeds from this offering for debt repayment and for general corporate purposes. Our U.S. revolving credit facility is scheduled to mature in October 2011 and accrues interest at LIBOR plus 0.425% per annum. Affiliates of certain of the underwriters are lenders under our U.S. revolving credit facility and will receive their pro rata share of repayments thereunder from the net proceeds of this offering." That last bit is critical. The company's $1.5 billion credit facility, on which it had $707 million outstanding as of December 31, will be the direct beneficiary of the offering as the entire $707 million amount would be paid down with the proceeds. And what entity benefits from this paydown: none other than Bank Of America, otherwise known as Merrill Lynch!

Ah, good old circular conflicts of interest. To summarize: i) Merrill, which is probably not too happy with having lent out Kimco $707 million on its credit facility, underwrites a $720 (including a 15% overallotment) stock offering for which it gets $20 million, ii) Merrill's analyst changes the stock from a Sell to a Buy, causing it to pop 30% in one day, and allegedly allowing participants in the offering to sell their shares at a 30% gain in a day, a mindblowing annualized return, iii) Kimco uses to proceeds to repay Merrill's credit facility, cleaning out any credit risk exposure Merrill might have with respect to Kimco's underperforming properties and operations.

At least Schmidt can sleep with a clean conscience after putting the following disclaimer in his report: "I, Craig Schmidt, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in this research report."

Another point: on March 25, another REIT, AMB properties, on which ML also previously had a Sell rating, raised over $500 million in stock - ML was not a lead arranger on the credit facility, which would end up being repaid with the offering proceeds, but was a lead underwriter on the equity offering. Another ML analyst, Steve Sakwa raised the stock from a Sell to a Neutral (5 day after the event mind you), not a Buy, on the offering. If the deleveraging thesis was indeed the critical issue here, does it not stand to reason that both stocks would have gotten the same rating (either Neutral or Buy) based on the same catalyst?

Zero Hedge, for one, hopes that Cuomo is reading Zero Hedge, as this kind of conflicted circularity would never have been allowed in the Spitzer days. Additionally, on a recent trip, this author stumbled upon a mall in a major metropolitan area where a Michael's store (another LBO special) had recently vacated thousands of square feet of retail space: the beneficiary of this lack of future cash flow: Kimco Realty Corporation.

In conclusion - to those that managed to get in on the stock offering: congratulations. The 30% return in one day is nothing to sneeze at. To all those other retail and institutional accounts, who piggybacked, and all day were buying the shares sold by the follow-on participants (likely using Merrill's brokerage desk as an intermediary, thereby generating even more profits for the company), hopefully you see something about the dreary mall REIT space that Zero Hedge is missing. Then again, as these purchasers are likely the very same people who are convinced that all the bad news in this market are lagging indicators, with all the seasonally adjusted "good" news are leading, the fair price of KIM to them is likely much, much higher. We hope they are right: in the meantime it never hurts to look at a cash flow or FFO model, and determine just how much cash a 38% equity-diluted KIM will be generating in the future as the bulk of its mall tenants either go bankrupt or decide they simply can not afford the rising rents that retail REIT operators hope to charge.
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45 comments:

Anonymous said...

until people start getting locked up for this fraud it will never change. and because I highly doubt that will ever happen the US equity market will be continue to fall apart until the last bagholder uhh i mean shareholder says F this and starts putting money in his mattress. the level of corruption is past that of a third world dictatorship.

qadi said...

This is why I love the TSX: they don't even pretend to enforce the rules there.

Anonymous said...

Why hope that Cuomo reads ZH. Send it to him!

maximus said...
This comment has been removed by the author.
maximus said...

GGP issued additional stock not so long ago.... price was mid 20's or even higher....

how'd that work out for them????

there are many more examples....

the games will continue until the masses refuse to play. Currently, the message of hope trumps the message of truth....For now....

Maximus
http://4best4worst.wordpress.com/

Anonymous said...

your title actually implies that the criminal behavior had left Wall St. it didnt leave, it just morphed into a different form.

But What do I Know? said...

Did you see the markup yesterday in the REIT's--which disappeared (to the tune of 5%) in the aftermarket? What happened there--or did I miss an announcement?

Anonymous said...

Tyler,

Can you investigate whether David Goldman is correct in alleging that Larry Summers was selling CDOs in 2007 when he worked for DE Shaw. http://blog.atimes.net/?p=552

faustroll said...

Very well done. Well written. Well thought out and absolutely damning. That is the very REIT pressure point that Minsky discusses in "Stabilizing"; the commercial bank as lender of last resort in REIT Ponzi debt financing of commitments must be repaid or the game is over.

Looks like the game will go on...

Thanks again, and keep up the much needed work. Reason and free markets lie somewhere out there in the future.

Gentlemutt said...

As Faustroll noted, well done and well-written indeed.

So, can we expect lots of equity issuance for companies now in debt to the major underwriters? That would be a fun scorecard to publish.

Tyler, who do you think was buying this Kimco offering? Pension funds?

5U said...

Tyler, thanks for posting this. You did a much better job than I could.

The KIM fiasco only proves that it is OK to act like Jack Grubman as long as it is part of the Political Agenda.

Expect to see more REIT offerings/pump and dump schemes. If it helps the banks tighten CRE credit spreads, makes them investment banking revenue AND increases trading revenue, this government endorsed Nirvana.

Jack Grubman should have been a REIT analyst. It is all about being at the right place at the right time.

pakman said...

Yo zero,

I am a host of a finance show in hong kong.

Will talk about this on weds.

Very interesting...

Max Leverage said...

As long as a broker/salesguy can approach a fund manager and offer him a deal that's really good for his bonus structure at the cost of the fund's long term viability, none of this stuff is going to go away.

I hope we've all learned a valuable lesson about who's best qualified to manage our money.

qadi said...

Now that the world is wise to what's up, the question is, will it persist into next week?

FD: short SRS into weekend... watever.

Tyler said...

gentlemutt - great question. interesting data point: When SPG did its follow on a week ago with GS, DB, and UBS as underwriters, Schmidt lowered his FFO estimates but did not raise the Neutral rating. Lenders on SPG's over $3.5 BN facility are BofA and JPM. Seems the correlation would be you need to be lender AND underwriter to see a rating raise by the analyst (wink wink). Of course I am not implying Schmidt will raise any other REITs' ratings if/when BofA were to do follow on offering for them. As another data point, Schmidt currently follows:
KIM - Buy
FRT - Sell
WRI - Seel
DDR - Neutral
GGP - Sell
REG - Sell
CBL - Sell
SPG - Neutral
CDR - Sell
EQY - Sell
PEI - Sell
SKT - Buy
TCO - Neutral
MAC - Buy

5U said...

This KIM article is great for Seeking Alpha.

It will drive more traffic to your blog also. That's how I found this blog.

qadi said...

Ah, he gave MAC a buy... must have been a "nearest neighbor" to KIM... bugger

navid said...

Moral questions aside, is this illegal?


(I have a feeling that Glass-Steagall would have prevented this conflict of interest between granting credit (lending) and use of credit (investing))

qadi said...

Nothing is illegal if it benefits the Regime.

Go long Fraud: you can't lose.

Retired Deal Guy said...

ZH - love your stuff, keep it up!

I'm not a securities lawyer, but from my experience this falls within the rules. That said, the timing is questionable -- particularly when you consider the fact that several HF's are fed up with ML on the lending side. A gift perhaps???

Under Reg M the "distribution" was complete assuming the overallotment option was exercised (safe assumption given the pop). So the report and the deal were separate from a legal perspective. Additionally Rule 139 provides a carve out for research if the report was published in the regular course of business and is not an initiation or re-initiation of coverage.

Bottomline: get ready for more of this nonsense. Chinese walls were porous before Spitzer and they were after Spitzer...

Links:
http://www.sec.gov/interps/legal/mrslb9.htm

http://content.lawyerlinks.com/default.htm#http://content.lawyerlinks.com/library/sec/sec_rules/reg_securities_act/general_rules/17CFR230_139.htm

Anonymous said...

tyler, thank you very much for that story!

Anonymous said...

The United States of Rot.......

Anonymous said...

Thanks for posting this Mr. Spitzer! When will you run for elected office again?

Anonymous said...

Anyone know where this Craig Schmidt guy lives? I'd like to pay hime a "friendly" visit.

5U said...

Craig Schmidt +1 212 449 1944
Research Analyst
MLPF&S
craig_schmidt@ml.com

Anonymous said...

Another nugget. Thanks ZH.

Anonymous said...

I stumbled upon this blog a couple of days ago. Excellent articles, especially this one and a previous one about AIG passthrough to banks. Love this blogger and his outstanding news/analysis. Only wish CONgress would investigate this.

aviat72 said...
This comment has been removed by the author.
Anonymous said...

ML-Implode just posted your article on the front page! Keep on spreading this juicy nugget around folks.

http://ml-implode.com/

Anonymous said...

The US government commits far bigger frauds and cover-ups than anything else out there. It is a monster that grew to frightening proportions. Without its backing all, the rest would not have committed what they did. So until the US government money making scheme machine is disbanded there is no point talking about such frauds.

Anonymous said...

You left the profit on the shoe trade - ML sells the over-allotted shares for a 30% gain. That's about $30M in gains in addition to the comp you've already listed.

Anonymous said...

Overallotment is allocated in the offering (at the offer price, not aftemarket price)...deal trades up, underwriter exercises the option and issuer receives proceeds...underwriters collect their gross spread on the incremental shares. If the stock trades below the offer price, the underwriters can use it defend the stock. I agree what happened is crooked, but it's not as juicy as it seems, particularly given there were other banks on the deal

eh said...

Great post Tyler. It's good to be reminded now and then that it's oftentimes a rigged game for unconnected individual investors and traders.

Anonymous said...

MER and C should have been shut down after their roles in the Enron debacle but Spitzer let them off with a 100 mill slap on the wrist plus support for his governor run in return for survival.
Both MER and C used similar bonus plans as Enron,compensating traders for deals before it was known if they would be profitable. they all used off balance sheet vehicles to hide bad investments from regulators and investors.
yet our government bails them out? until the system is purged we relive this financial nightmare over and over

Anonymous said...

Kinetics Funds


-95% in hedge fund assets in 2008 !!!!!

$5 Billion to $200 million

Bob said...

What is interesting is that they site his Sell recommendation with a $12.50 price objective while he upgraded the stock to Buy when the price had subsequently dropped to $7.10 while at the same time reducing his price objective to $10.50. That is the one glaring inconsistency or flaw in Zero Hege’s argument. And the analyst’s reasoning for the upgrade was that the equity infusion did indeed reduce refinancing concerns, which makes perfect sense. One thing that I can tell you is that since ML was in the process of doing or pitching an underwriting the analyst was precluded from issuing any research on the company (These are the rules post Spitzer). Thus, he was precluded by perhaps several weeks or months from issuing any research what-so-ever and probably why he was not able to upgrade the stock earlier once it fell below his previous price objective. Once the stock offering was completed then the analyst was once again allowed to publish on the company. And it certainly doesn’t make sense to still have a Sell rating with a $12.50 price objective when the stock is $7.10. So he had to publish something to change his rating or price objective or both, which he did. I am not defending this incident without knowing more of the details but I think it is incorrect or wrong to assume that this analyst was acting dishonestly.

5U said...

Hey Bob...I worked at the big banks.

They guy knew what he was doing.

Anonymous said...

Look like we can start to short this crab after another few days. Good blog!!!

Anonymous said...

Kimco and SPG picked the perfect time to do a secondary offering, which is toward the end of a bear market rally, and before earnings season. I think that they know that something is up, and this is the last chance to get it done before this mean reversion turns into another rout. I won't be surprised to see a flood of insider selling soon.

aviat72 said...
This comment has been removed by the author.
aviat72 said...

Are these credit lines being pulled or just being replenished so that KIMCO can use them as a cushion in future emergencies?

In any case, having to sell stock at a 12 year low to payback a credit line at 42.5 spread is not a vote of confidence. In a short week thought the big boys can make this rally last and KIM might hit the new price target *SOON*.

I am sure a lot of funds who had shorted KIM were delighted at the chance to cover without having to buy shares in the open market. They shorted at 2007 levels to cover at 2009 (err... 1996) levels. I will be disappointed if tax money is spent to bailout CRE. If the price action in the REITs is an indication, something might be cooking in DC.

A Price Action View on CRE

Anonymous said...

the same game was played at Alcoa (AA) over the last 2 weeks - huge offering followed by upgrades to allow participants dump their shares.

J Kim said...

The biggest Wall Street firms are also the worst culprit of manipulation. Witness this article from FT Alphaville on Golddman's analysts great job in talking up the oil price last year and caused the collapse of more than one company Sempgroup, and numerous airlines such as Cathay Pacififc and Singapore Airlines who were naive enough to believe Goldman's oil prices projections and took out massive oil hedging contracts. With oil today at $50, these 2 airlines are still losing billions as a result of these hedges. Needless to say , Goldman and Lynch profited handsomely from these manipulations.

Kinabalu said...

"Then things changed for the better briefly, when Spitzer came on the stage. "

Are you kidding? Spitzer settling for corporate fines instead of jail time for the perps is what allowed the poor behavior to persist. Milken spent 2 years in prison for actions that were paltry compared to what Spitzer was prosecuting.

Anonymous said...

מידע נוסף על
מניות בבורסה, מדדי מניות ומניות ארביטראז'