Short Selling Ban Is Dramatic, But U.S. Can’t Allow Firms To Fail For No Reason

The SEC’s 10-day ban on the short selling of financial stocks will undoubtedly spark a great debate on Wall Street, and the merits of the rule should be discussed, but let’s be honest, the government had to do something.

Morgan Stanley (MS) reported blow out earnings and a book value of $31 per share this week (a day earlier than planned, due to a sinking stock price) and the stock reacted by dropping 60% from $30 to $12 per share. Another day or two of that and the firm could have filed bankruptcy (and Goldman Sachs probably would have followed), even though it earned $1.43 billion on $8.0 billion in revenue for the quarter ended August 31st.

State Street (STT) drops from $68 to $29 yesterday on no news. The company issues a press release saying nothing is wrong and the stock recovers.

These are not stories of orderly markets that are functioning normally. If not this SEC ban, then what else should they have done to restore order? What are the alternatives?

When traders can have that much impact on a company’s fate because falling share prices for no fundamental reason can lead to bankruptcy within days, or the need to sell your company for a bargain basement price because you have no other choice, that is not an orderly market. It’s that kind of thing that causes panic and could create a 1987-like crash, or worse, a 1929 depression-like crash. If based on fundamentals, those events, while dire, are not something we should prevent. However, the events of this week were not based on fundamentals, they were based on speculators, false rumors, and panic.

I have no problem with short selling. But when unrelenting shorting can contribute to a company falling into a death spiral, a company that otherwise would have easily avoided such fate, I really don’t have a problem with banning shorting for 10 days to make sure our market can function normally.

If short sellers and/or hedge funds want to bet against these firms, all they have to do over the next 10 days is buy puts. If their fundamental analysis is correct, they’ll make a killing from those bets. But those bearish bets should not directly contribute to the demise of our country’s largest financial institutions. Just because Bear Stearns and Lehman Brothers were bad investment banks, Morgan Stanley and Goldman Sachs should not be forced to fail too when they have managed their risks far better and are still in the black to the tune of billions of dollars.

Full Disclosure: No positions in the companies mentioned at the time of writing

UPDATE 9/19 3:35PM ET
Lots of reporting in the media that the rally today is due to short covering because of the new short selling rules. This is nonsense. The rule bans shorting of financials starting today. It does not force previous shorts to be covered. Not only that, if you short stocks and you know you won’t be able to make new shorts for the next 10 trading sessions, and the Dow soared 400 at the open today, why would you cover your existing shorts? If you really believed in your negative view of the stocks, and the prices went up at a time when you were banned from shorting more shares, you would certainly keep the shorts on rather than covering them. -CB

One By One, Financial Firms’ Issues Being Resolved

The recent leg down in the markets has been due, in large part, to the fact that specific firms have been forced to seek individual solutions to survive, whereas before we were more focused on general economic statistics. We are attacking each one and the list I came up with above is almost completed. What are the next shoes to drop after these are resolved? If there aren’t any/many more, could that mark a short-term bottom?

Commercial Banks Ready To Pounce On Goldman Sachs And Morgan Stanley If Market Forces Them To Deal

People are correct when they point out that the market is forcing the stronger investment banks, Goldman Sachs (GS) and Morgan Stanley (MS), to do a deal with a deposit institution even though they are making money and aren’t liquidity strained. It is a shame, but when your business model requires short-term funding sources from the market, and at the same time the market is crushing your stock based on fear and not actual problems with your business, you might have little choice.

Today we are hearing that Morgan Stanley is talking with several parties about a capital investment or an outright merger. Wachovia (WB) is on the short list of potential merger partners. If Goldman and/or Morgan are forced to do a deal by the marketplace, you can bet that the buyer will be getting a steal (like the one many thought Ken Lewis could have gotten if he waited a day or two to buy Merrill Lynch).

The result is that investors should look at any deal for Goldman or Morgan as a potential opportunity. The Wachovia story is interesting because they clearly have their own issues to deal with right now (notably $120 billion in Pick-A-Payment mortgages in California they are trying to rework with borrowers). A bank like Wells Fargo (WFC) would be in much better position to take on one of the two remaining investment banks, or a troubled bank like Washington Mutual (WM).

At any rate, any deal for GS or MS done because of market reaction and not on business fundamentals is likely going to be done at an absolute bargain basement price (even better than the Merrill Lynch deal).

Full Disclosure: No positions in the companies mentioned at the time of writing

Ridiculous Item of the Day

Have these people been alive and breathing in recent days? Hilarious…

From the San Jose Business Journal:

Merrill Lynch & Co. Inc. shareholders have filed suit against the brokerage firm’s chief executive, John Thain, and its board over Bank of America’s proposed $50 billion buyout of the company. The lawsuit, filed in New York State Supreme Court, claims the deal is wrong, unfair and harmful to Merrill shareholders. The suit says the defendants have clear and material conflicts of interest and are acting to better their own interests at the expense of Merrill public shareholders.

Americans: Add AIG To Your Investment Portfolio!

As one of ~300 million Americans, we each now own about 0.000000002663333% of AIG.

I think the Fed did the right thing here by requiring some financial benefit in return for such a huge loan. Not only do taxpayers get a 79.9% equity stake in AIG, but we also are collecting some hefty interest on the deal, to the tune of LIBOR plus 8.5 percent.

Why The Fed Should, And Probably Will, Give AIG A Loan To Help Fight Off Bankruptcy

The Federal Reserve Bank serves as the “lender of last resort” in this country, meaning they stand ready to lend when nobody else will. For this reason, I think the government will give AIG the bridge loan it believes it needs to try and avoid filing bankruptcy.

Keep in mind that this is not a bailout. A bailout is a hand out. A loan is money that needs to be paid back, and in AIG’s case, probably within a relatively short amount of time. The Fed should even be able to charge interest on such a loan to make some profit for the taxpayers.

Reasonable minds can argue whether Bear Stearns and Lehman Brothers should have been treated equally or not, but given that AIG is solvent and simply needs a short term loan to sell some of its assets to eager buyers, the Fed should step up and play its role of lender of last resort. With the Dow up now, after being down 175 this morning, it appears Wall Street is pricing in some kind of resolution sooner rather than later. Let’s hope so…

Full Disclosure: No position in AIG at the time of writing

Lesson Learned from Failed Investment Banks: Leverage Feels Great Until It Bankrupts You

How do companies with such great assets go belly up within days once a cascade of bad things start happening? At the outset of 2008 we had five major independent investment banks and now we have two (Goldman Sachs & Morgan Stanley). A core reason is that the leveraged finance business model is a very poor one. It allows you to make a killing when times are good, but on the flip side it can bankrupt you within days when the tide turns. That is not a risk-reward scenario that companies should embrace.

Imagine how easy it is to get caught up in the leverage game. Pretend you have $10 and are allowed to borrow $300 against it, for a leverage ratio of 30-to-1 (a common ratio for investment banks in recent years). If you are paying 5% interest on the loan and can earn just 6% on the $310 in capital you now control, you can earn a profit of $3.60 ($18.60 less $15.00 in interest) on your original $10.00 in capital for a return of 36%. Pretty cool, huh?

Well, only when you actually make money on what you are investing the money in. Consider the same example when your investment loses 5% of its value. After paying interest on the loan, you only have $279.50 left but still owe $300 to the lender. Now you are in trouble. To pay back the loan you need to borrow another $21.50 (if someone will lend it to you) and even if you can do that, you have lost your original $10 in capital.

The leveraged finance game, at least at the level these investment banks were playing it (leverage ratios of 25, 30, or 40 to 1) is very, very dangerous. Investors beware.

A final note about business models. AIG (AIG) is trying to sell assets in order to raise at least $40 billion in new capital because the ratings agencies may downgrade their credit rating if AIG can’t come up with the new money. Reports are that a ratings change could bankrupt AIG within days if that downgrade should occur.

What kind of business model is this? Moody’s and S&P downgrading your credit rating results in your company going bankrupt in 2-3 days? Not only is that simply ridiculous in terms of relying on one party to remain solvent, but even more unreal is that these are the same ratings agencies that don’t have a clue how to rate anything. Remember, they had triple A ratings (the highest possible) on packages of subprime mortgages! If subprime mortgages are of the highest credit quality, what would prime mortgages be considered?

Short term, the unraveling of these firms will hurt, but long term, from what we are learning about these business models, maybe they should never have been anywhere near as big as they were to begin with.

Full Disclosure: No position in AIG at the time of writing

What BofA Gets By Passing on Lehman, Gobbling Up Merrill

We can certainly second-guess Bank of America (BAC) deciding to buy Merrill Lynch (MER) today rather than tomorrow or next week, when the price could have been meaningfully cheaper. There is speculation that the government pressed Merrill do to a deal now, so as to avoid another weekend bailout session later. Not only that, but by acting now BAC ensures they get Merrill, rather than having to pass up on a chance that may not come along ever again.

While the price they paid (and whether it proves justifiable based on long-term profitability at the Merrill unit) will be one of the key factors in the deal’s ultimate success, my job as a portfolio manager and a BAC shareholder is less about speculating on whether they could have paid less tomorrow and more about what they are getting for the deal they actually announced, a stock swap of 0.86 shares, valued at $29 per MER share based on Friday’s closing prices.

While the bad assets are abundant at Merrill’s investment banking arm, it is important to remember that the crown jewel of this deal is the Global Wealth Management division, not the investment bank. MER owns 50% of Blackrock (BLK) and has a network of nearly 17,000 financial advisors.

The BLK stake is publicly traded, so we know that is worth $14 billion. The Merrill Private Client Group does about $3 billion per year in pre-tax net income, so a conservative multiple on that division of 10x gets valued at another $30 billion. In sum, that comes to a $44 billion valuation for about 45% of MER’s revenue base, which excludes their entire investment banking operation.

Bank of America shares are trading around $29 each this morning, which values the Merrill deal at ~$43 billion. As a result, BAC shareholders are getting MER’s investment bank for free. There is a price to pay for that luxury, however, because further writedowns of Merrill’s bad assets will now be incurred by BAC. Long term though, it is hard to argue that BAC can’t make this deal successful over a multi-year time frame. Jut how bad future writedowns are will play a big role in determining such success.

Even Oppenheimer’s Meredith Whitney, the extremely bearish analyst on the banks, today pegged Merrill Lynch fair value at between $27 and $35 per share. At today’s prices, BAC is paying less than what Wall Street’s most bearish analyst thinks the company is worth. That can’t be a bad thing…

All in all, this deal is much like the Countrywide one. BAC is accepting near-term problems for the possibility of tremendous long term upside. I would much prefer that strategy to the one a company like Wachovia (WB) implemented when they bought a mortgage company (Golden West) and an investment firm (AG Edwards) at the top of the market. At least BAC did so when the firms were in distress, and might have gotten a bargain as a result. Time will tell.

Full Disclosure: Long shares of BAC at the time of writing

BofA’s Lewis Still Making Deals, But Now Aiming For Distressed Assets

Lots to get to this morning, so I’ll be writing on several topics throughout the week, but first let me address a reader question re: BAC.

Shepherd writes:


If the wires are correct, it looks like Lewis paid a premium to purchase Merrill Lynch. I’m curious why you hold BAC, given that he seems to have an almost emotional need to acquire things, which gets in the way of negotiating the best price for his shareholders. My guess (admittedly from afar) is that he could have done better…

Shepherd, your characterization of BofA CEO Ken Lewis and his love of acquiring things is spot on. Earlier this decade BAC has acquired companies like FleetBoston, MBNA, and U.S. Trust, and paid full prices for all of them. As a result, BAC rarely traded above 10x earnings since most of their growth was coming from acquisitions, not organic growth.

During that time Peridot clients did not hold BAC shares. It was only after the subprime crisis started to bite the big banks that I invested in BAC. There were a couple of reasons I chose BAC. First, relative to their size, BAC had less subprime exposure than their large cap bank peers. They did take writedowns, but given they are the largest bank in the nation, firms like Citigroup, UBS, and Merrill Lynch had far more exposure. On that front, BAC’s losses were manageable, and they were forced to dilute shareholders far less than others via capital raises.

The second reason was that BAC is the largest bank by deposits in the country. As we have seen with the investment banks like Bear Stearns and Lehman Brothers, without deposits to fund your business, capital can dry up overnight and a freefall can result.

On the acquisition front, people have criticized the Countrywide deal, but Lewis actually bought them on the cheap. Time with tell if he gets a decent return on the investment (I suspect he will over the long term, despite short term losses), but buying distressed assets on behalf of shareholders is far better than what he used to do (pay a huge premium for assets that were already fully priced).

The Merrill Lynch deal is a similar situation. We can argue if the price he paid was fair, but at least he is buying on the cheap. That will increase the odds of a very successful deal. I’ll have more on the Merrill deal in another post to examine exactly what BAC is getting for their money.

Full Disclosure: Long shares of BAC at the time of writing