Post infusion blues

January 16, 2008

Is the smart money really that smart? Remember how, back in August, B of A’s $2.0 billion investment in Countrywide was interpreted as a vote of confidence? Investors voted by bidding up the shares significantly the day of the announcement. Watching CNBC this past week, the Power Lunch anchor asked Felix Rohatyn if the conventional wisdom, that BofA’s planned acquisition of CFC signaled a bottom, was correct. Felix, playing the cheerleader like a good investment banker, said yes.

That got me thinking. Have past capital infusions signaled bottoms? Clearly not, as the table below demonstrates. Starting with the fifth column from left, I’ve listed the stock price just prior to the announcement of the capital infusion. The “high, post” column lists the stock’s high after the announcement. Then the date when that high was reached. And if you scroll to the right, you’ll see where the stocks’ prices are today, and the percentage change from the high after the announcement…..drum roll please…..

So is the smart money smart? Well in some cases no, for instance B of A’s August investment in Countrywide. But as was pointed out on Minyanville yesterday, the latest capital infusions are coming with so-called “ratchet” provisions. What are those you ask? Let Minyan Peter explain (hat tip to Mish):

In the terms for both the Merrill (MER) and Citigroup (C), convertible transactions are “ratchet” provisions. For those not familiar with the term, when an issuer agrees to a ratchet, it gives the security holder the right obtain better terms in the future under certain conditions.

Specifically, (and in a nutshell) should Merrill issue more than $1.0 of additional convertible equity, or Citigroup $5.0 billion in the next year at a lower conversion price, the holders of the deals announced this morning can get the new price.

For existing Citigroup/Merrill shareholders, should such a further capital raise occur at a lower stock price, their dilution will be significantly compounded because of the ratchet.

At least to me, the inclusion of a “ratchet” for both of these companies suggests that, while still available, the true price for incremental capital has gone up significantly.

Shareholders in troubled financial services companies should not take this lightly.

Remember when AAPL was forced to drop the price of the iPhone from $499 to $399? Obviously that pissed off all the folks that had paid $499 only a couple months before. AAPL gave prior customers a “ratchet provision” of their own, offering them rebates on the higher price they paid.

Sovereign Wealth Funds clearly want to protect themselves from further deteriorations in the stocks of the financial companies they’re bailing out. Put simply: they’re not confident in the price they’re paying today. Or if they are, they want to be protected if they’re wrong. It doesn’t matter, the result is the same: existing bank shareholders may have their holdings diluted twice. Today, as they sell pieces of their banks to SWFs in exchange for capital infusions and also in the future when SWFs come back to demand rebates on the price they paid in the first place. They only get a rebate if these companies have to go back to the well for more capital and are forced to offer a better price at that point. But that seems likely to me for some reason!

These investments may protect bank balance sheets, but they ARE NOT bullish signals on the continuing earning power of the banks’ underlying businesses.


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