ARS Buybacks: Wachovia Follows the Herd

Going once…going twice…bought back! Wachovia (WB) this morning announced that it has settled with the New York Attorney General’s office regarding an investigation into its marketing of auction rate securities (ARS). As market watchers are aware, the market for these complex debt instruments collapsed in February, early on in the ongoing credit crunch. Essentially, auction rate securities are bonds with variable interest rates (often re-set weekly) and indefinite maturities. Investors could get out of the bonds on a weekly basis if they no longer liked the interest rate or needed their cash. In many cases, these bonds were marketed as alternatives to money market funds. The bottom fell out of the ARS market when the large financial institutions which issued them refused to act as a buyer of last resort and no other buyers came forward. At that point, the $330 billion market for ARS’s imploded and investors were left unable to access their funds.

Just how well Wachovia and other banks understood the risks ARS’s posed is unclear, but it had marketed ARS’s as “cash alternatives” with implied liquidity. While Wachovia is neither admitting nor denying wrong doing in this case, it has opted to settle with the Attorney General and buy back nearly $9 billion worth from investors. In the last two weeks, five investment banks have bought back nearly $35 billion worth of ARS’s, including: Citigroup (C), JP Morgan (JPM), Morgan Stanley (MS), UBS (UBS) and now Wachovia. The only hold-out thus far in the industry-wide investigation—which has ensnared 25 firms—is Merrill Lynch (MER). Merrill had better get its legal team prepared because it seems destined for a courtroom battle with NY AG Cuomo.

The Wachovia settlement should cover about 40,000 investors who were allegedly misled about the risks involved in auction rate securities. In addition to the financial strain of the buyback, WB must now increase reserves to cover legal costs. Wachovia was also fined $50 million. The impact of the settlement is estimated to take eight basis points from Wachovia’s Tier 1 Capital ratio, which is a measure of a bank’s capital adequacy or its financial footing. This may prompt Wachovia to raise more capital, potentially through issuance of more stock.

As for our valuation of Wachovia, after the stock’s horrid few months it appears undervalued when compared to historical norms. For example, price-to-revenue has historically ranged between 1.78 and 2.41 times, but the current ratio is well below normal at 1.01. However, Wachovia in all likelihood is going to have negative earnings for at least the next few quarters. Also, the dividend has been slashed recently in an attempt to shore up capital which is always an insight into management’s prospects for the company. So, although we have a Buy rating on the stock—strictly from a value perspective—we would only advise purchase for the most patient and risk-tolerant of investors. It is very possible that in 3 to 5 years the stock will not be at such depressed levels, but it will most likely be a bumpy ride in the meantime.

Comments

[madasiwannabe:]

If the GSE's are sneezing, the banks have pneumonia. Billions worth of ARS buybacks added to the loss column of their balance sheets can't be a good thing. Many are already struggling with subprime bloated portfolio's and because the property values have fallen against an originated 125% LTV combined mortgage, the housing bill is not going to help. Rolling deliquency filings from 3 months to 12 only prolongs the inevitable.

Soon to add to the problem is the news that most are looking at the house of creditcards coming down. If I was going to pick a winning horse in the financials I would go with Freddie and Fannie. They seem like they are high risk, but truth is, if they collapse, a black hole will form and suck the rest down anyways.

2008 Aug 16 09:17 AM

[debtacid:]

Wachovia is going to get 9 billion dollars from stock dilution for a stock that doesn't even list a P/E ratio? Who would buy it? Bernanke? Paulson? The Chinese? Without ARS, CDOs, or MBS, what is the business model that is going to get WB out of this hole?

2008 Aug 16 11:24 AM

[Blackbeard:]

It is worth noting what Wachovia is actually buying back. WB will be repurchasing only ARS that are still locked up in failed auctions, with the buybacks occurring in stages between this fall and next summer. The majority of these are preferred issues from closed end mutual funds. WB is probably working with the issuers of these securities to arrange for a buyback of these securities over the next few months/years. These securities continue to pay interest at a default rate while they are locked up. Wachovia can borrow from a low cost source (discount window or other lending facility) and offset the borrowing cost with income from the default interest rate. They won't make much money from it, but it gets some negative publicity off their back and shouldn't require extra capital raising for this particular buyback. I expect WB to have to issue more stock before this is all over (lots more and messy too), but doubt it will be related to this settlement.

2008 Aug 16 12:39 PM