S&P to Rally If Financials Hold: A Huge 'If'

I came across this call by David Kostin, Goldman Sachs’ (GS) Chief US Portfolio Strategist, in which he says the S&P 500 could have 12% upside to 1,400 by year-end. This part in particular caught my eye:

Bullish signpost to watch for: (a) Moderation of losses and successful capital raisings for S&P 500 Financials; (b) Steps taken to resolve the GSE crisis; and, (c) Pockets of stability in housing. Key downside risks: (a) A significant, negative event in the Financials sector; (b) Evidence of a global recession; and (c) Unexpected negative US macro news.

The idea that capital raises by major financial firms will go a long way toward dispelling rumors and realization of chaos is not new. But a key component of any successful capital raise is that the deal would have to be done at a reasonable cost to the issuing institution. I’m finishing up a presentation on the market outlook for the BC Investment Club, and one of my leading concerns (besides the obvious difficulty of raising capital) is the costliness of any financing that might be obtained.

As was noted in mid-August, even traditionally well-regarded financial firms like Citigroup (C), American Express (AXP), and AIG (AIG) have to offer paper at huge spreads (risk premiums) to Treasuries. Citigroup priced a deal at Treasuries + 300 bps, American Express at Treasuries + 400 bps, and AIG at Treasuries + 475 bps. Wells Fargo (WFC) did a five-year callable preferred offering at Treasuries + 550 bps, and CFO Howard Atkins seemed happy just to have gotten the deal placed, noting that at least Wells still has access to the capital markets.

Of course, these kind of spreads are becoming systemic as this chart (from before the magnitude of Lehman’s troubles became known) shows:

Image Credit: Bespoke.

But, of course, there is the huge caveat that Kostin added – namely, “a significant, negative event” involving one or more financial companies. And it now looks like that is set to happen, given that Bloomberg is reporting both Barclay’s (BCS) and Bank of America (BAC) seem unwilling to make a deal for Lehman (LEH). In a special Sunday trading session predicated on a Lehman bankruptcy filing, an index of credit default swap spreads was up 35% since the close on Friday, to a level surpassing what the index hit in mid-March during the Bear Stearns drama.

Personally, I’m a bit nervous about the impact this could have on Primus Guaranty (PRS) and their credit default swap book – it looks like the Fannie/Freddie obligations Primus wrote swaps on will be fine (they’re trading at or above par, thanks to the government backing) – but the specific exposures to Lehman are unknown, as are any ripple effects this could set off.

Conversely, some have argued it’s possible that Lehman can fail without creating some sort of systemic meltdown – and if that were to be true, the market could rally as Kostin predicts. An orderly runoff would likely wipe out the common stockholders, but it is impossible to say how far the pain would spread up through the capital structure, or how long it would take for that scenario to play out. For what it’s worth, Lehman’s long-term borrowings consist of $110.5 billion in senior notes, $12.6 billion in subordinated notes, and $5 billion in junior subordinated notes, as well as $7 billion in preferred stock.

Given not only the enormous degree of uncertainty, but the magnitude of importance a resolution to that uncertainty will have, it seems foolish to take this as a classic “buy fear” moment unless an identifiable, company-specific edge exists.

Kostin’s second possible risk scenario – a global slowdown – has gained momentum of late, and that is tomorrow’s topic.

Disclosure: none

Comments

[sumosama:]

You have to look at the ABS the banks were selling...for example, WFC was selling subprime car loans...and still making a profit at 9.75% interest. You are confusing selling corporate bonds with selling ABS...

2008 Sep 15 01:01 PM