Thoughts on the Worthless Equity Value of Some 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) (click on chart to enlarge).



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 (C) and Bank of America (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 on the fact 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 portfolio 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 occasional one page memo now and then.

Comments

[apppro:]

These markets are HIGHLY illiquid and really do not represent anything more then professional short funds trying to further manipulate bond prices in order to further destroy the common stock so they can cover their short positions.

WHEN IS ENOUGH ENOUGH?? ‘The Shorting of America’ must stop!! Or at least we need to have these [edited] pay for it by: WINDFALL CAPITAL GAINS TAX OF 65% ON ALL SHORT SALES RETROACTIVE TO 01/01/08!!

Mar 12 07:10 AM

[wobatus:]

Options are often sold underwater and no one questions that they have some conceivable value. Yes, shares of banks are options on the banks continued existence.

Mar 12 07:12 AM

[RiskTrade:]

As I understand it your view is that the currently depressed bank sub-debt prices imply that sub debt holders are likely to suffer either coupon deferral/ or out right capital loss and therefore anything in the banks capital structure below sub debt gets wiped out. I agree this is very possible but it is based on one critical premise -i.e. that current prices of sub debt are correct. Clearly, no one knows if the current prices are correct and so what if sub-debt prices have fallen too far and and are actually cheap ? Would that not imply a better survival probabilies for the equities ?. Point is trying to extract long term equity survival probability from sub debt market prices is pointless.

Mar 12 08:45 AM

[GreenGuy:]

How about a windfall "undeserved bonus" tax of 75% on all Wall Street, mortgage company and megabank compensation of more than $500,000 retroactive to Jan. 1, 2001?


On Mar 12 07:10 AM apppro wrote:


> WINDFALL CAPITAL GAINS TAX OF 65% ON ALL SHORT SALES RETROACTIVE
> TO 01/01/08!!

Mar 12 09:50 AM

[Mr. Big:]

One only needs to look into the CDS market to get a feel for what the market truely thinks of Citigroup. Over the past couple of weeks, credit spreads have breached the 1000 basis point mark... literally implying junk status. Cost of protection has since come in but it rests at a still highly elevated 805 basis points (1-year).

So I'm not so surprised at what the bond prices are indicating. There is REAL risk that Citigroup is technically bankrupt right now and not worth a single penny. NOBODY....and I mean NOBODY can tell me what Citi's true mark-to-market is. Much of Citi's riskiest assets reside in a black hole where valuation models fail and credit ratings are questionable. Perhaps the losses relating to these assets are enough to completely wipe out the equity base as well as carve into the debt base? Perhaps there aren't any losses at all? Fact is, nobody knows....and if somebody did, nobody would believe him.

Don't blame the short sellers (I'm not one of them). Put the blame squarely where it belongs: CITIGROUP'S MANAGEMENT. They brought it upon themselves (and everyone else) with their reckless pursuit of profits without the regard for prudent risk management.

Mar 12 10:07 AM

[monday1929:]

Look at a chart of the Chinese Stock market. They do not allow Shorting. Same Crash. Now, Think. No, really, Think.
The people to whom your anger should be directed are those who destroyed the system (which was an unstable system anyway). The Bankers who commited Crimes. The "regulators" who were bought off. The politicians from both parties who were bought off. Any shorts who commit a crime.
I do not blame those whose Delusions and delusional buying caused a Mania. Why blame legitimate shorts who recognized the delusion, in many cases tried to warn others about it, and traded their beliefs? I will gladly pay the 65% tax, if you rebate my losses from betting too early on the collapse YOU caused by bidding prices to DELUSIONAL levels. Enjoy your Granite counter-tops.


On Mar 12 07:10 AM apppro wrote:

> These markets are HIGHLY illiquid and really do not represent anything
> more then professional short funds trying to further manipulate bond
> prices in order to further destroy the common stock so they can cover
> their short positions.
>
> WHEN IS ENOUGH ENOUGH?? ‘The Shorting of America’ must stop!! Or
> at least we need to have these asswipes pay for it by:
>
> WINDFALL CAPITAL GAINS TAX OF 65% ON ALL SHORT SALES RETROACTIVE
> TO 01/01/08!!

Mar 12 11:10 AM

[Mr. Big:]

Stopping shorting is just a PR move. One can easily take on short positions by longing put options.

Anyhow, I was thinking more about what the bonds are implying. Perhaps it's not pricing in bankruptcy....but pricing in the concessions that the bond holders may have to make to allow Citigroup to remain viable. Maybe a complete bankruptcy would result in a recovery rate of only 50 cents on the dollar....so 70 cents is not such a bad concession.

Mar 12 11:17 AM

[MattZN:]

CDSs are even less liquid instruments, only an idiot would use them as an indication of anything.

Probably the most liquid debt instruments are the bank preferreds. Even so these are about 5x less liquid then the common stock. They've had wild swings to absurdly low valuations and thus absurdly high yields, but they have also recovered significantly in the last few weeks. The massive disconnect between the preferreds and common has led to some interesting investment opportunities in recent months.

I'm not sure what the author means by most bank debt being held by insurers and foreign investors. Where did that idea come from? It's being stated as fact without a single data point to back it up. Anyone can hold bank debt.

-Matt

Mar 12 11:18 AM

[Fabien Hug:]

Risk for preferred equity and bond holders is real but I still think that this bond and CDS trading has more to do with opportunity than fundamentals. I hope that C's first quarter results will confirm Mr. Pendit declarations from early this week and that it was not another manipulation. If Q1 results don't confirm, brace yourself.

Mar 12 11:49 AM

[Buckoux:]

posted by apppro:
"WINDFALL CAPITAL GAINS TAX OF 65% ON ALL SHORT SALES RETROACTIVE TO 01/01/08!!"

I deplore the use of the taxing power of the state to be used as a form of punishment for business outcomes that disagree with some citizens and the populist agendas of certain political parties. The tax system, like church and state, should be separate from crime and punishment. The tax code should fund the government and not your personal umbrage, apppro! The use of windfall taxes, capital gains taxes and taxes levied to punish success are backward ways of Europe and are very Un-American. If you don't care for the lawful outcome of certain legal financial transactions, then have such transactions declared a crime. Otherwise, leave the skillful and the innocent to their profits.

disclosure: not short seller, long on finance. "Bullish on America"!

Mar 12 12:12 PM

[sether:]

Targeted higher taxes and more regulation will hopefully prevent 'business outcomes' like we have been experiencing over the past year. Skillful and innocent. That's priceless. Fleas and ticks are skillful and innocent, and I grant you, play an important role in our ecology. However it becomes necessary at times to exterminate them when they threaten to overwhelm the host.


On Mar 12 12:12 PM Buckoux wrote:

> posted by apppro:
> "WINDFALL CAPITAL GAINS TAX OF 65% ON ALL SHORT SALES RETROACTIVE
> TO 01/01/08!!"
>
> I deplore the use of the taxing power of the state to be used as
> a form of punishment for business outcomes that disagree with some
> citizens and the populist agendas of certain political parties. The
> tax system, like church and state, should be separate from crime
> and punishment. The tax code should fund the government and not your
> personal umbrage, apppro! The use of windfall taxes, capital gains
> taxes and taxes levied to punish success are backward ways of Europe
> and are very Un-American. If you don't care for the lawful outcome
> of certain legal financial transactions, then have such transactions
> declared a crime. Otherwise, leave the skillful and the innocent
> to their profits.
>
> disclosure: not short seller, long on finance. "Bullish on America"!

Mar 12 05:08 PM

[@TexasER:]

If no one can tell me what a company's assets are worth, or what their liabilities really are, then I think a $0 valuation is more than fair.

Especially if that company is a bank.

Mar 12 06:00 PM

[PainfullyAware:]

"Targeted higher taxes and more regulation will hopefully prevent 'business outcomes' like we have been experiencing over the past year." - Sure, and slavery makes sense as well from this perspective; then their is no other option but to conform; Freedom Is Further Purged From The System.

Short Sighted Solutions Make Detrimental Unintended Consequences.

Taxes will still be avoided by those with enough money to pay someone full time to "Game The System" and Regulation Does Nothing Without Enforcement.

How about stopping the ability to make "Off Accounting Book" instruments. Problem Reduced.

You Can Not Legislate Morality. The best you can do is make the field even and visible. Special Case Legislation is a Slippery Slope to discrimination.

The Laws That Apply To You Should Also Apply To Me; No Exceptions Or Special Cases.

Be careful When you wish for the "Blind Giant" of government to be Judge.



On Mar 12 05:08 PM sether wrote:

> Targeted higher taxes and more regulation will hopefully prevent
> 'business outcomes' like we have been experiencing over the past
> year. Skillful and innocent. That's priceless. Fleas and ticks are
> skillful and innocent, and I grant you, play an important role in
> our ecology. However it becomes necessary at times to exterminate
> them when they threaten to overwhelm the host.

Mar 12 06:46 PM

[Moon Kil Woong:]

Letting banks modify or defer losses even more will give a short term rally to the market but make the recovery as long and painful as it takes for banks to write off the bad assets. Similar to the accounting changes after the dot com bubble made this downturn worse by letting banks keep derivatives losses off the balance sheet.

Water down accounting and you inevitably destroy the stock value for the entities you water down the accounting for. After all, what type of investment are you making if you have insufficient information about their liabilities and profit and loss.

Bu the good news will be a nice relief rally until the next shoe drops. Then what a big shoe that will be. I am against lenient accounting rules. It violates the tenants of a capitalist market. Furthermore, doing so denies the owners of the company (shareholders) the right to see the fundamental facts about the company they own putting them hostage to whatever the executives spout.

Shareholders should sue for fair financial disclosure. After all, as owners, it's their right to know what they own before the shorts get to party over the folly of the company execs.

Mar 12 10:35 PM