Wednesday, March 11, 2009

On The Worthless Equity Value Of Banks

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. Sphere: Related Content
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James said...

So, is this going to lead to more fireworks in the coming weeks?

Anonymous said...

And only a fool would bet on the equity market over the bond market. It's astounding that anyone is buying the common in these names knowing what is coming down the line for them....Behind door #1 we have massive unmitigated shareholder diluton! And behind door #2 we have an eventual government takeover!

Andrew Hofer said...

"Since most bank debt is held by insurers and foreign investors, and only a small portfio is owned by mutual funds"

Having looked into several domestic insurance portfolio and some of the biggest fixed income mutual funds, I can tell you this debt is VERY widely held domestically. I see the assertion in the BBG article, but it is bogus. Among others, PIMCO has been loading up on it.

Alex said...

I think you are mixing up the arguments for bank debt. The Barclays analyst is saying the SENIOR bonds are cheap, not the SUB.
Can't a bank miss or delay payments of the coupons of Sub debt without "defaulting?" I thought this was the point of Sub give banks equity-like capital.
However, taking a haircut on senior debt = bankruptcy. A SENIOR bondholder who is not paid could FORCE a company into liquidation, thereby totally wiping out the tranches below him. No?

Advant Guard said...

So do the bond holders have any information that is not public? Or are they just paying attention to the multitude of bloggers who claim to know of trillions of dollars of losses at banks without any factual basis? The fact that the bonds are trading where they are, is only proof of hysteria, not any indication of actual losses at this bank or any other.

As for the conversion from preferred to common, if you check your notes it was completely voluntary, which is why Citibank approached the government to add a sweetener of government participation.

babar ganesh said...

why would senior bonds take a hit?

Anonymous said...

1. "Among others, PIMCO has been loading up on it." - Because BG expects the government to make sure senior bondholders don't lose, and perhaps get taken out at par?

2. "why would senior bonds take a hit?" - because market believes that these banks are worth way less than even the face amount of their senior debt? And this assumption may well be correct imho.

Tyler Durden said...

Advant: i would say that asset managers are too arrogant to care about what blogs have to say, but care about capital preservations. claiming they are hysteric is itself hysteric. As for the voluntary conversion, anyone who opted out would be stuck with a preferred that would be stripped of all benefits (dividend, structural seniority) effectively putting them below the common. If you really think it was "voluntary" i have some share of citi for sale.

xtreeter said...

I am betting that to distinguish unsecured senior from sub debt is a moot point (at least prior to bankruptcy).

A)A bankruptcy filing for Citi and the likes will not be allowed to happen.

B)To miss a coupon payment on the sub, although technically possible, but is in really impossible. Since such actions will no doubt lead to Citi's trading partners/counter parties/customers loosing faith and abandoning Citi all at once, forcing a bankruptcy filing.

disclosure: I recently took a long positions in Citi's Sub with cost is the 50's.

Alex said...

xtreeter: I think I agree with your statement that if a bank were to skip a coupon on sub, that it would be catastrophic for the continuing operations of the bank.

That said, what is the point then of issuing sub-debt??? It seems the only value to the bank is that you can issue sub-debt without hurting your senior credit rating much. So...banks issue bonds at higher yields because of flawed ratings agency assumptions.

Have any banks other than DB extended rather than called any sub-debt? (After DB didn't call their LT2 bonds, their equity got pounded.)

Anonymous said...

While not a good sign, it is technically not true that these prices imply that the equity and pref are worthless.

Assuming that the price of the debt only reflects the risk neutral assessment of expected loss (i.e credit risk ) and not things such as funding, liquidity, volatility, interest rates, etc. once has to remember that expected loss equals probability of default times the severity of the loss given default.

It is possible that the price represents a high probability of a default with a (relatively) low loss (in which case the equity is most likely worthless) or a low probability of default with a high loss, in which case the equity does have value.

I'm betting on the former, but felt the need to be pedantic.

Anonymous said...

I've only dabbled in debt securities via the NYSE (Comcast CCW, for example). Is this the method others are using as well? Or is there some other way to buy either senior or subordinate debt?

This area of +10% yields definitely has my interest, and thanks to the posts. They've definitely added some new perspectives.

Anonymous said...

Anon at 9:02, to find any debt security, the best route is to run a search through a Bloomberg terminal with the criteria you've set. If you don't have access to a Bloomberg, you can probably do an OK search by going to the NASD's TRACE public website. After you find the issues you need, then call your broker to locate the bonds if he dosen't already have them.