Ah it seems like only yesterday, but it was a whole two weeks ago when E*Trade (NASDAQ:ETFC) appeared to be on the verge of bankruptcy. Now Citadel has infused them with $2.5 billion, pulling them back from the brink.
I think this is noteworthy on a variety of fronts. But most important is that it is possible to make a reasonable investment in a company with negative net worth. Many commentators, including some of my readers, have questioned why anyone would put equity capital into various subprime-tainted companies. And I get their logic. Why put cash into a company laden with losses, especially if the losses are so great as to create negative net worth? It would sure seem like throwing good money after bad.
It's relatively simple to build a model showing why sometimes investing in a negative net-worth situation makes sense. This will be important for any number of companies, from Washington Mutual (NYSE:WM), to Ambac (ABK), MBIA (NYSE:MBI) or FGIC, to Citigroup (NYSE:C) and Freddie Mac (FRE).
Bear in mind that I have no view of the E*Trade deal, since that is a company I don't follow at all, and therefore have no idea what may or may not make sense in their particular case. But the model I will show here could apply to anyone who has suffered losses in excess of their theoretical book value.
First, let's assume a company with two lines of business: Line A is performing well, earning ROA of 5%, Line B is creating large book losses. In the case of E*Trade, Line A would be their brokerage and B their home equity. Or with the monolines, A would be their munis and B their ABS/CDOs.
Let's say that prior to Line B blowing up, the company's balance sheet looked like this:
Line A Assets: $80 billion
Line B Assets: $20 billion
Total Assets: $100 billion
Debt (avg cost = 6%): $60 billion
Other Liabilities (e.g., unearned premium, loss reserve, deposits): $30 billion
Total Liabilities: $90 billion
Equity: $10 billion
Now let's say that Line B loses 55% of its asset value, so it falls to $9 billion (loss of $11 billion). For the sake of argument, assume that the loss of 55% is known and no further losses are coming. If we hold Line A's assets and overall liabilities constant, we get -$1 billion in net equity.
But Line A is still performing, earning a ROA of 5%, or about $4 billion/year. Let's assume that the remaining Line B assets also have 5% ROA, or $450,000, but that the $11 billion loss is dead money. The debt is costing the firm $3.6 billion. Let's make life easy and assume the deposits or other liabilities don't have a cash cost. So the firm is still earning positive cash flow of $850 million. That cash flow has value.
But obviously this company needs some capital, particularly if they are a regulated entity that has minimum capital requirements, or an insurer who needs a certain credit rating. Let's say they need $5 billion in net equity in order to satisfy whatever requirement.
So could someone come along and buy the whole company for $6 billion? With $900 million/year in positive cash flow, the ROE on a $5 billion investment would be about 14%. If the buyer was someone with relatively low cost of capital, that investment might work just fine.
Of course, mergers and/or strategic investments aren't always about ROE alone. Some may have strategic value to a larger firm. Obvious examples would be Countrywide (CFC) or Washington Mutual. When Bank of America (NYSE:BAC) put $2 billion into Countrywide earlier this year, it was widely viewed as a first step toward a possible merger in the future. It seems as though Bank of America viewed the convertible preferred as a cheap way of acquiring some of Countrywide's equity. This would have made a future full merger cheaper. Of course, CFC's stock has fallen precipitously since then, but that's another story.
Equity infusions are sometimes about supporting a previous investment. CIFG and ResCap are good recent examples. With financial companies, sometimes all they really need is some cash to keep the ship afloat.
Anyway, this is obviously a highly stylized example, and I'm sure you all will pick it apart in the comments, so have at it. Let me leave you with some food for thought (or commentary):
You are never bankrupt as long as investors are willing to keep funding you. In other words, running numbers and coming up with a negative net worth doesn't necessarily equal insolvency. If so, the U.S. Treasury would have been bankrupt a long time ago.
There are more forces working to keep a company going than working to drive it under. A whole host of people, from management to investors to investment bankers will work on finding solutions. With rare exceptions, no one actually working on driving a company under.
Disclosure: No positions in any company mentioned except Freddie Mac (debt).