Lehman's Preferred Offering: Bullish for Stocks 17 comments
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Investment Banks Update: Lehman Brother's Preferred Offering
Lehman Brothers (LEH) has announced a preferred stock offering to raise $3B in new capital. The preferred will have a yield between 7-7.5% and a conversion premium of 30-35% over the common stock. Though the deal has not closed yet, the word is that the offering is three times oversubscribed. Lehman is running the book themselves so there is no underwriting fees to be paid here and all the capital raised will go to increase Lehman's equity base.
Lehman's stock has been under considerable pressure
following the run on Bear Sterns (BSC). There were massive out of the money put
purchases that contributed to the fear cloud. This has also attracted a lot of
retail shorts who are expecting another Bear Sterns-type buy-under. Perhaps
they do not realize that even deep out of money puts ($25 strike with stock at
$40) can easily double or triple in value with a $5 movement in stock-price;
the increase in volatility in large downward moves increases the value of the
puts.
The news about the preferred sale sent Lehman's share down to as much as $35.30 from their 4:00PM close of $37.64. The Fast Money crew raised questions about why Lehman had to raise capital in this environment if they were not facing any liquidity issues. Some investors are concerned about the dilution faced by the common equity holders; others are concerned about the potential effect on the dividend for common equity holders.
Asset Sale versus Raising Capital
I think it is important to review the offering in its broader context. It is very clear that investment banks will have to de-leverage. They can do this by either selling assets or raising more equity. In the dysfunctional markets we are in, selling assets is not the most profitable option. However interest rates are low, so raising equity capital via preferred offerings is not that expensive.
Why Raise Capital Now?
Some observers have questioned the need to raise capital when Lehman has been outspoken in announcing that their liquidity situation is excellent. However, we are in an environment where well capitalized investment banks can generate high return on equity with very little risk.
Investment banks now have access to the Fed's balance sheet where they can borrow from the Fed against a variety of collateral, including asset backed securities. The result of the first Term Securities Lending Facility Auction showed that investment banks borrowed at a spread of 33 basis points, i.e. they could use their investment grade bonds as a collateral and get treasuries (as good as cash) at a rate equal to the yield of the treasury plus 0.33%.
So Lehman Brothers can use the $3B they raised to buy $30B in AAA rated mortgage bonds which are currently yielding about 5.5%. They can use the TSLF and park these bonds with the Fed borrowing at the rate between 2.5 to 3%. This allows Lehman Brother's to book a spread of 300 BP leveraged at 10x translating to 30% return on equity.
The 7% dividend on the preferred pales in comparison with 30% ROE! Do note that even before the Fed stepped in LEH had an ROE of around 20%. Reduction in leverage levels will reduce the ROE in the future but it will still be higher than the 7% dividend yield on the preferred.
Balance Sheet Strength
Raising the cash allows Lehman to be better positioned to weather any future writedowns in its portfolio. It also allows them to put their cash to work if distressed liquidation temporarily lowers the price of high quality securities.
Dilution Risk
There is some concern about the dilution of the common equity. Based on the available news, the preferred will be convertible at a premium of 30-35% of the current stock price. This provides sufficient room for the stock price to grow before the conversion
Market Confidence
Lehman's ability to raise a large amount of capital on decent terms while it was under a cloud will help the overall confidence of the capital markets. It will dispel market rumors and help the markets to return to normal sooner. The Treasury and the Fed have been encouraging the banks to raise more capital and will welcome this move. I believe Lehman's move is bullish for the price of the common stock, and investment banks in general.
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This article has 17 comments:
Fix the problem, not the symptoms please.
you write that the $3B generated from the preferred allows them to purchase $30B of AAA MBS which gets repo'd at the fed at about 2.5% and all according to plan, generates 300 bps on $30B or 3000 bps on the original $3B equity. One question, where does the 10x leverage come from and where is the cost of that borrowing? it appears in your example LEH is able to borrow for zero cost?
Have we learned nothing?
The Fed has declared that they will continue to lend to the banks as long as the market is dysfunctional. The AAA bonds themselves are backed by the GSEs so unless they go under, the principal is safe. The only risk is interest rate movement which can be hedged.
stochvol:
You borrow from Peter (Fed) to lend to Pan (the bond seller). Suppose the IB buys $10M bonds and puts $1M down. It needs to borrow $9M. It goes to Peter and deposits the AAA bonds and in exchange gets treasuries (with some haircut say 10%) worth $9M at a spread of 33bps. These treasuries are as good as cash and the bank pays Pan with the $9M in treasuries (or by selling them and generating cash) and $1M in their on equity. If there is a spread of 300 bps (5.6% AAA yield, 2.6% borrowing cost), the ROE on the 10% equity is 32.6%. The haircuts for AAA bonds are smaller than 10% so in principal the bank can leverage even more than 10x.
Surely you jest!
1) How does one hedge the interest rate risk on MBS? Bond/note futures? Interst rate swaps?
2) Does this hedge have no cost?
3) A 'AAA' rating means that there is no principal risk?
The strategy Vikram now describes (his original piece left ouf the 'hedge') was termed 'Risk Controlled Arbitrage'. back in the mid 1980s.
Investment banks lured unsuspecting investors (mostly savings and loans) to buy 'AAA' (I believe Vikram means FNM or FRE guaranteed) MBS using 10-1 leverage, hedge the interest rate risk and earn this gigantic spread! Alas, Risk Controlled Arbitrage killed more savings and loans than the real estate collapse in 1990.
That some now recommend the same strategy for investment banks is surely karma!
What I have outlined is an example of how an IB can put the cash they have to use thanks to the low cost borrowing they get from the Feds. The reason the Fed is offering this facility is to encourage the IBs to take some risks and unfreeze the credit markets. That is why it was a great move for LEH to raise money right now.
IBs are in the business of taking measured risks. They do well most of the time but mess up sometime. Right now we are in an environment where the Fed and Treasury has clearly announced their intention not to allow a meltdow. BSC was the sacrificial lamb; after that they will backstop the financial system.
In this environment to expect GSEs to default on their bonds is like a 5-6 sigma event and banks will take their chances on that. If the GSEs default the entire global financial system is in touble, so there are greater things to worry about than LEH. The Fed has made it clear that they will continue the lending facility as long as the market is dysfunctional. This also means that LEH could buy the AAA GSE backed bonds at a much wider spread than the norm and profit from the eventual spread tightening. They will take comfort in the knowledge that the Fed will hold the bonds till the markets become fluid (and the spreads tighten).
globaleconomicanalysis...
And all that needs to happen is to have the value of the MBS drop by 3% and your ROE of 30% goes to 0%, 4% and you have -10% ROE and so on. How far does AAA MBS drop when the TSLF goes away--probably a lot more that 3%. So this seems to me like a game of chicken between any bank undertaking this trade and the fed. But you definitely do not want to be holding the bag (AAA MBS) when the fed pulls the TSLF. And I do not think that a 4%+ drop agency debt is a 5+ sigma event.
BTW, do you know the number of ">5 sigma" events that have happened in the past 100 years? Any mention of "but its an XX sigma event" is usually spoken in or around the time a manager takes on way too much risk and then blows up. As in, "yes I lost all your money but it was a 6 simga event". Funny how many of those 6 sigma events have happened in the past nine months (at least 3 that i count) and yet if we are measuring daily, a six sigma move should happen roughly once every 3,824,885 years.
1. My example was to illustrate how the Fed's inexpensive lending makes this the perfect time for IBs to raise new capital to work with.
2. The link you posted is talking about private label Alt-A mortgages. These are neither prime nor are they backed by the GSEs; the market is treaging them like that. Private label Alt-A mortgages are trading at a huge discount; UBS sold them at 70c/dollar to PIMCO; subsequently Thornburg Mortgage's equity holders have been diluted by 20x after TMA was forced to raise capital to meet margin calls on Alt-A bonds they had purchased.
To be eligible for GSEs the mortgage has to be to a prime lender, have a minimum of 20% down payment, and be conforming. GSEs backed mortgages used to trade at a very narrow spread to treasuries. The Fed is essentially backstopping them now with the TAF/TSLF; they could buy them in the open market as some observers have suggested but by using the TAF/TSLF they are letting the IBs take the spread. This is helping rebuild the IBs balance sheets and enhance their ability to lend again.
Note that Caryle Capital's failure happened because GSE paper lost a few points last month. It was the widening of the GSE paper spread which prompted the Fed to act. The GSE spread is already tighening we speak and the IBs can also benefit from principal appreciation as the market unfreezes and spreads tightens further. The Fed will continue the lendng facility as long as the market is dysfunctional
3. The GSE are government sponsored agancies with an implicit backing of the US Government. For the GSE AAA bonds to default, these GSEs will have to become insolvent and unable to fulfil their debt obigations. The US will not allow the debt obligations to fail that unless the Treasury itself is insolvent (the equity might be wiped out). With the Treasury's ability to raise money by increasing taxes and issuing treasury bonds, I feel that this scenario is truly a 5 or 6 sigma event. Given that the Roman Empire fell just 2000 years ago, I think it is highly unlikely that the United States too will fail ;).
No offense, but you seem to have confused the concept of interest rate risk with credit risk.
Anyone who buys MBS on repo has enormous price risk. This price risk cannot be easily hedged. Even an inefficient hedge has significant costs. And MBS hedges are notorious for backfiring due to the prepayment option on MBS. Your post makes absolutely no mention of either this risk or the costs associated with the hedge.
LEH could implement your trade by simply going long note futures and selling calls against those futures. The yield would be on the order of 15% (much higher than what is available on the MBS).
And you attack those who suggest that you have ignored price risk with some confused commentary about GSE defaults.
To be sure, you original post only mentioned 'AAA' MBS,nothing about GSE. We all know what has happened to 'AAA' MBS. No one has suggested that the US govt will allow GSE to default. That has nothing to do with the price risk of these instruments.
I would only suggest that your commentary shows how little we have learned from the current experience.
0. I am not sure why the time I take to clarify an opinion or respond to a question is seen as an attack. Have I said something offensive?
1. Your point about the original post not mentioning GSE's backed AAA is correct. I wish I could correct it.
2. More important: do not miss the forest while looking at the trees. IBs are in the business of taking measured risk. They take it everytime they underwrite a deal, make a market in a particular security or take a prop position. Right now the Fed has made the profits from taking the risk significantly more than what it traditionally is. As a result an IB which has capital can profit from the environment. This is what makes the timing great.
I gave an example of how leverage works using AAA MBS; IBs typically have a LOT more leverage than the 10x example I used. The Fed allows them use a 2% haircut for GSE backed bonds which can be used for 50x leverage.
3. Modeling RMBS performance is a complex task with a LOT of assumptions about prepayments, and of late default rates for non-GSE backed bonds. However, even you agree that there is very little chance of principal loss on GSE backed bonds. Not to digress too much but let me address your questions about prepayment risk in the context of an IB:
-> Prepayment happens is small steps; it is highly unlikely that an entire pool will be prepaid in a single month or quarter.
-> Prepayment implies a return of principal. For example, as you pay off your mortgage, the note holder does not lose principal even if the value of the note goes down. Note that the market already prices its current expectations of prepayment/interest rate risk and its effect on the PV of the bonds cash flow; LEH is pretty good at it being the provider of a huge variety of tools used by buy side firms to model them.
-> The IB can use that cash returned by prepayments to pursue what it deems is as the most profitable investment. The IB can reinvest it and buy more bonds or lend it at out at LIBOR which is still significantly higher than the borrowing cost from the Fed (look at TED spreads) or do whatever it wants with the new capital.
-> For an IB, it is all about spreads. A buy and hold investor in RMBS has to consider the reinvestment risk since the prepayments increase at a time of low interest rates and change the traditional notion of a bond rising in value when interest rates fall. This affects the secondary market pricing of the bonds. However an IB primarily cares about is the:
a) The spread between their borrowing costs and the coupon on the bond (which is heavily in the IB's favor). And the spread is so high that the IB can easily weather any UNEXPECTED prepayment related risk. The market will already price the expected prepayment risk in the current bond price.
b) The spread at which the bond trades with respect to an index (say LIBOR or the treasury). Currently GSEs spreads have widened compared to historic norms so it is a great time to buy and park at the Fed, assuming that the spreads will eventually regress to the mean.
There are several notes out there saying that it is a great time to invest in funds/ETF who buy GSE backed paper. Clearly these market observers do see something similar to what I have been saying.
The mortgage pool that i linked to was, and still is, a AAA pool. I sent the link more as an example of how little a AAA rating means right now esp when dealing with MBS. Sorry for the confustion. I'll say only a couple more things here, I think tallindian and I have harassed you enough :)
First, your point that the agency-treasury spread has begun to tighten seems to me to get the cause and effect out of order. The spread tightened after the TSLF because banks knew they could make the trade you mention, not because the underlying credit quality of the GSE paper somehow improved. The point being, when the TSLF ends it is reasonable to expect that spread to widen out again. And to my point, you don't want to be the bank holding those MBS when the fed pulls the punchbowl.
More fundamentally, you and I differ in how likely we perceive a bad event happening at the GSEs--and there are others like me even on seeking alpha:
seekingalpha.com/artic...
When articles like that start showing up your six sigma event just became more of a 2 or 3. Unlikely? Perhaps. Utterly improbably and so therefore a good, calculated risk? Heck no.
I also think that there is a misunderstanding of exactly what the GSE's can (and do) hold. It is most certainly not limited to only 20% down and conforming. This is from page 82 of FNM 07 annual report:
We own and guarantee loans with non-traditional features, such as interest-only loans and negative-amortizing loans. We also own and guarantee Alt-A and subprime mortgage loans and mortgage-related securities. An Alt-A mortgage loan generally refers to a mortgage loan that can be underwritten with lower or alternative documentation than a full documentation mortgage loan but may also include other alternative product features. A subprime mortgage loan generally refers to a mortgage loan made to a borrower with a weaker credit profile than that of a prime borrower. We reduce our risk associated with these loans through credit enhancements, as described below under “Mortgage Insurers.”
I recommend you go to that section and keep reading. Notice for example in the next table that 20% of FNM conventional single family business is 80%+ LTV, up from 10% in 06 (double! yikes!). 12% is alt-a etc, etc. Now, consider all that risk FNM has on its books and how those loans are being priced in the credit default world (check markit.com) and then consider the gearing that the GSEs maintain. With that kind of leverage how much of their pool has to default before their equity is wiped out...
Well, we are on opposite sides of this trade. If it doesn't work out for you call me up--I should be a bit richer, I'll buy you a beer :)
Good luck to you.
Thanks for your comments.
Again my point is that the Fed has significantly increased the profitability for IBs when the take risks so LEH is raising cash at a time when they can really profit from it. The market reaction on the day after I wrote this article seems to have vindicated my post.
GSE spreads had really widened (when Carlyle failed) and the spreads are tightening, and much more likely to be tighter an year from now simply because the Fed backstop is now in place.
A bulk of GSE backed paper continues to be prime/confirming/20% down. GSEs have been issuing bonds for a long time and the Alt-A/Subprime/neg-amo... boom is very recent. You have to look at it as a total percentage of GSE's outstanding debt. And even if the GSEs fail, it is the equity holders will be wiped out. The bond-holders are likely to be made whole by Uncle Sam simply because the fallout is going to be catostrophic. I continue to believe that GSE bond's defaulting is at least a 4 sigma event (I will give that to you ;) ).
The Fed Window rumor turned out to be false, but it is clear that GSE bonds are almost as good as Treasuries now. The spreads tightened today as the implicit backing of the GSE bonds is becoming more explicit. Treasuries fell as there is concern that the debt of the US Treasury will no longer be 'AAA+' once the GSEs bonds get formally get the blessing and the treasuries debt burden increases by a huge amount.
From a big picture perspective, I think fear is what is completely in control. The GSE have about 1.5% in loss reserves. For all the equity to be wiped out, we need a 7.5% default rate with a 20% severity rate on the entire portfolio. With a bulk being confirming 80-20 loans, where the replacement value of the home (the unofficial floor) not very far from the home price, the severity rates might be lower except for the loans in 2005-2007. But equity holders have to be *very* concerned.
It is time for the Resolution Trust Corportation Part II, to end the uncertainty; the fear of the future loss is going to harm a lot more people than the actual losses which the Resolution Trust might take.
The spread tightening today was 'the most extreme narrowing of yield spreads ever' according to UBS.
And I continue to believe that a default on the GSE default is at least a 4 sigma event (April 3 comment) with the pendulum shifting towards 5 as a United States battered by a weak economy, high oil prices and a general crisis of confidence, has to step in to stabilize the boat in the short term.