The Inquisitive Mind

The credit-markets are showing signs of life again. The buy-under of Bear Sterns (BSC) and subsequent actions by the Fed to allow Investment Banks to access the discount window using asset backed paper as collateral seem to be having the right effect. The market cheered when Lehman Brothers (LEH) was able to place an offering of preferred convertible stock at reasonable terms. This was followed by news of Thornburg Mortgage (TMA) and Washington Mutual (WM) raising equity capital to continue their operations. Though the terms were highly dilutive for the existing equity holders, the fact that the firms were able to raise capital without the intervention of the US government or Sovereign Wealth Funds was a welcome sign.

Leverage Loans: Market Unfreezing

Citigroup (C) is close to completing a transaction to place more than $12B of leverage buyout related loans to a group of private equity investors. The loans were sold at around 90c to the dollar, a much better price than the 15-20% loss which was being projected earlier. The amount placed amounts to about 25% of all leverage loans Citigroup is currently carrying on its books.
A few weeks ago it would have been impossible to imagine that a beleaguered bank like Citigroup would be able to place such a large amount of loans at such reasonable terms. This is another indication that the credit markets are now unfreezing. Private capital is now sensing a once in a lifetime chance to pick up high quality paper at deep discounts and they are now diving in by the droves.

This deal has the potential to be the harbinger for more placements, as other buy-side firms, itching to put their money to work, start scooping up the leveraged loans. Given Citigroup’s beleaguered negotiating position, this deal also establishes a floor for pricing of such placements in the future. This bodes well for banks who are sitting on a huge amount of leveraged buyout paper, which was fuelled by the private equity boom of 2006-2007.

The placement also means that the leverage buyout market will gradually start opening up again. Perhaps the biggest benefactor will be the buyout of Clear Channel Communication (CCU) which is currently stuck in litigation. The private equity firms taking CCU private were unable to agree on the financing terms with the funding banks. The banks were desperately looking for the flimsiest pretext to renege on their funding commitments since they expected to book 15-20% loss as soon as the deal closed.

Write-Ups Anyone?

A few weeks ago I had written a post which explored the level of write-downs taken by banks to account for the sub-prime related assets. My conclusion was that the write-downs were extreme since they were based on extremely pessimistic marks in a dysfunctional market. As a result there is tremendous potential for write-ups as the credit markets start functioning properly. A number of market observers are now talking about the same thing, with the Fast Money crew specifically noting that Morgan Stanley (MS) was extremely aggressive in booking the $9B+ write-down and will see an upside within a year.

Online Shopping and Google

CNBC’s Margaret Brennan had an interesting piece about the effectiveness of marketing dollars in online retail.

“
…
What is interesting to me are the different ways that Internet stores are reaching customers to bring them “in store” — online.
One of the most effective ways is also one of the cheapest: Forrester’s Research shows that e-mails sent to repeat customers by stores involves the cheapest marketing cost ($6.85 is the average cost per order), while yielding a high average order value ($120.27 average order value.)
Search engine shopping is also among the cheapest ($8.63 average cost per order) while yielding a high return ($109.73 average order value.) These cheap marketing tools are helping retailers maximize profits.
…
“

Earlier this year, I had written a post in response to an article by Henry Blodget, where I had suggested that during an economic-slowdown, marketing dollars will increasingly move online since they allow retailers to get the quickest bang for their marketing dollars. The data from CNBC seems to confirm that search is a highly effective method of generating sales, especially among new customers who traditionally have much higher acquisition costs than existing customers.

Though online retail grew by 17% year over year, it still represents just 7% of the total retail market, leaving a tremendous amount of upside. High gas prices are also pushing customers to shop with their mouse instead of driving to a store. They not only save the time and the gas money, but are also able to comparison shop to get the best deal. Many online retailers do not charge sales-tax for out of state residents, and offer free or discounted shipping which is helping push more shoppers online.

The effectiveness of search as a medium to drive sales bodes well for the undisputed leader in search, Google (GOOG). Google’s stock has been under immense pressure this year with questions about how the economic slowdown will affect online advertising. Financial and mortgage related firms have been cutting back on their online marketing. The unfreezing of the credit markets and government actions to spur mortgage refinancing means that we are sitting on the cusp of another big boom for mortgage vendors. I expect the mortgage vendors to come back aggressively into the online advertising market to make up for the lack of business over the past year.

Lehman Brothers has announced a preferred stock offering to raise $3B in new capital. The preferred will have a yield between 7-7.5% and a conversion premium of 30-35% over the common stock. Though the deal has not closed yet, the word is that the offering is three times oversubscribed. Lehman is running the book themselves so there is no underwriting fees to be paid here and all the capital raised will go to increase Lehman’s equity base.

Lehman’s stock has been under considerable pressure following the run on Bear Sterns. There was massive out of the money put purchases which contributed to the fear cloud. This has also attracted a lot of retail shorts who are expecting another Bear Sterns type buy-under. Perhaps they do not realize that even deep out of money puts ($25 strike with stock at $40) can easily double or triple in value with a $5 movement in stock-price; the increase in volatility in large downward moves increases the value of the puts.

The news about the preferred sale sent Lehman’s share down as much as $35.30 from their 4:00PM close of $37.64. The Fast Money crew raised questions about why Lehman had to raise capital in this environment if they were not facing any liquidity issues. Some investors are concerned about the dilution faced by the common equity holders; others are concerned about the potential effect on the dividend for common equity holders.

Asset Sale versus Raising Capital

I think it is important to review the offering in the broader context. It is very clear that Investment Banks will have to deleverage. They can do that by either selling assets or raising more equity. In the dysfunctional markets we are in, selling assets is not the most profitable option. However interest rates are low, so raising equity capital via preferred offerings is not that expensive.

Why Raise Capital Now?

Some observers have questioned the need to raise capital when Lehman has been outspoken in announcing that their liquidity situation is excellent. However, we are in an environment where well capitalized investment banks can generate high return on equity with very little risk.
Investment Banks now have access to the Fed’s balance sheet where they can borrow from the Fed against a variety of collateral, including asset backed securities. The result of the first Term Securities Lending Facility Auction showed that investment banks borrowed at a spread of 33 basis points, i.e. they could use their investment grade bonds as a collateral and get treasuries (as good as cash) at a rate equal to the yield of the treasury plus 0.33%.

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The airwaves are brimming with stories about the financial loss incurred by investors and financial firms due to the mortgage market meltdown. What is often ignored is that foreclosures also have a debilitating effect on communities. Home values fall reducing the tax receipts of local governments; empty homes become an eye-sore for the entire neighborhood and invite vagrants. Investors and owners of foreclosed homes will have to endure the pain of their imprudent financial decisions. However, the impact of foreclosures on communities can be reduced by creative planning.

In the past mortgages were held by local banks who could work with homeowners in trouble to delay foreclosure till the hard times pass. However, in the days of securitization the owner of the mortgage is a business entity, a trust created to buy mortgages and issue securities. There are mortgage servicing organizations who handle the book-keeping aspects but they do not have any skin in the game. They do not have enough financial incentive to help homeowners stay in their homes.

Root Cause Analysis

Many home owners who are in trouble took sub-prime Adjustable Rate Mortgages (ARM) with teaser rates which reset after two or three years. After the reset point, the rates would go up to 500 to 600 basis points above the LIBOR rate (typically the 12 month LIBOR). Even the initial teaser rates were in the 7-9% range, much higher than what most prime home-owners pay.
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Friday morning was shaping out to be the much awaited follow-though day for the 400 point Dow rally on Tuesday. The equity markets had retraced a bulk of the gain and then bounced back on Thursday. The CPI number on Friday morning was benign and we seemed to be set for the races.

A few minutes before the market opened the news about the Fed led bail-out of Bear Sterns came out. Bear was under pressure throughout the week with rumors of a liquidity crunch. Bear’s CEO Alan Schwartz had tried to dispel these rumors earlier this week; however his public statements seemed to have worsened the situation. Bear’s prime brokerage customers started pulling their cash; traders cut back on trades with Bear as a counterparty. There was a run on Bear and on Thursday night Bear’s executive decided to seek help. A firm using a large amount of leverage needs time to unwind them. With the credit markets in a spin, it was not possible for Bears to raise the cash.

Bear’s downfall was being predicted in the options market. There were tens of thousands of March put contracts bought at strikes of $20 to $30 below where Bear Sterns was trading. The put-buyers were confident that something big was going to happen very soon. It is not known who bought the puts but I will not be surprised if it were entities related to those who were pulling their cash out from Bear.
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S&P was out with a report today saying that the banks are more than half-way through in recognizing losses attributed to sub-prime mortgages. They revised their estimate of total losses up to $285B from $265B but this is much less than the estimates put out by investment banks: $325B from JPMorgan Chase, $400B from Morgan Stanley and Goldman Sachs, and even $600B from UBS.

This week different government agencies have started taking serious action to introduce liquidity into the MBS secondary market. The Fed’s decision to allocate $200B to exchange AAA rated MBS held by investments with Treasuries helped stabilize the market. Later today, news came out that Congress was considering more efforts to stabilize the mortgage market. A proposal which will allow the FHA to offer $300B more in guarantees to help refinance distressed mortgage got some attention. Treasury Secretary Paulson introduced proposals to introduce rules to regulate over the counter markets which are currently unregulated, to restore confidence in counterparties and prevent future bubbles.

The message being sent is that the Fed, the Congress and the Treasury are now serious about intervening in the MBS market to ensure stability. The equity market rallied and Treasuries sold off after digesting the news of Carlyle Capital Mortgage Fund’s liquidation. This indicates that the markets are now internalizing the beginning of the end of the credit-crunch. The equity markets were frozen because of the credit-crunch; the attention shift away from credit problems bodes well. Investors can now start looking at the fundamentals of equities instead of being stuck in a technical trader driven market.
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This weekend’s Barron’s has article by Jacqueline Doherty titled “Google’s Next Stop: Below 350?” The main thesis of the article is that analysts have not reduced earnings estimates for Google to account for the expected reduction in clicks and corporate ad spending. The article recommends staying clear of the stock until Wall Street recognizes that Google’s revenues will be hurt by an economic slowdown and management starts cutting expenditure in non-core areas. To be fair the author acknowledges that Barron’s (specifically she) has been consistently wrong about Google in the past; others have called her out for her hand-waving articles.

Further her assertion that Wall Street have not come down is incorrect. Yahoo! Finance shows that earnings estimates for the current quarter have fallen from $4.86/share to $4.65 over the past 90 days. Estimates for FY08 have fallen from $20.69 to $19.98.

I feel that one big challenge which Google faces is that they have consistently spurned Wall Street. Google’s IPO was not managed by the big banks that lost out on the massive underwriting fees big IPOs generate. They do not provide earnings guidance to make the job of analysts easy. Wall Street is forced to follow Google because of its performance; not because Google reaches out to them.

Similarly the financial press is not too enamored of Google. Google represents the biggest threat to Madison Avenue and traditional media advertising. As a result whether it is raising privacy concerns or questioning their future growth, it has a tendency to put a negative spin on Google.

In an earlier post I had wondered whether Wall Street properly values the brand loyalty which Google inspires. Barron’s comment’s on spending in non-core areas seems to highlight that the financial press and Wall Street continues to refuse to see the forest for the trees. In this article I will try and translate Google speak into Wall Street speak to help them understand a few things.
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Shares of Thornburg Mortgage are down more than 40% to 2.01 in the after hours after the company said that it was unable to meet a $28 million margin call from JP Morgan Chase, one of its lenders. JP Morgan has decided to exercise its right to liquidate the collateral under a $320 million financing arrangement Thornburg defaulted on. This notice of default from JP Morgan triggered cross-defaults with other lenders who can now demand their money back. Unless a white knight emerges, this might be the end of Thornburg Mortgage as we know it.

The contrast with other companies failing due to the sub-prime mortgage mess could not be more ironic. Thornburg is a well respected mortgage lender with high lending standards and one of the lowest default rates in the business. It primarily lends to high income individuals who take out Jumbo mortgages on their homes and rarely suffers a loss on its portfolio. Company insiders have been on a buying spree since last fall and have purchased more than 1.26 million shares in the open market.
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The air-waves are full of talk about recession, inflation and stagflation. Longer term interest rates are increasing while the Fed continues to cut the Fed Funds Rate, to bring short term rates down. A number of observers are questioning whether the Fed’s decision to focus on growth rather than inflation is the right one. Conventional thinking suggests that lower Fed Funds Rate will increase inflation since it spurs economic activity and growth. However, there is not much written on the mechanics of inflation, and the amount of control the Fed has to manage inflation.

In the current context, I would like to view inflation along the following three dimensions:
• Commodity Costs: The cost of the basic natural resources
• Labor Costs: The cost of wages paid to workers
• Infrastructure Costs: The cost of using existing (or building new) factories, hospitals, or computer networks

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The tech-ticker on Yahoo! Finance had an interesting article about Apple zealots posting extremely critical messages in response to an article by Barron’s Eric Savitz which highlighted negative comments by Toni Sacconaghi, a Berstien Research analyst. It got me thinking about why companies have such loyal fanboys?

Two Silicon Valley companies come to mind, Apple and Google. The stock for both these firms has been hammered by recession fears. Though the sell-off after the big run-up of last year was expected, the size of the fall has taken many by surprise. Having spent time working both in the valley and Wall Street, I often wonder whether Wall Street put sufficient value to the value of the brand which each company represents.
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Apple’s COO Tim Cook made a presentation at the Goldman Sachs Technology Investment Symposium earlier today. The call was very bullish and tore to shred all the doubts that had been raised by different analysts about Apple’s business prospects. MacDailyNews has live notes about the call.
Some highlights:

• iPhone sales target of 10 million affirmed
• Mac has huge headroom and has immense mind-share. Apple passed Dell as the largest provider of portable computers to higher education.
• iPod revenues grew 17% year over year. 40% of all iPods sold to consumers who did not own one.
• iPhone contracts may not be exclusive in other countries; a lot of carriers are interested in the phone since it is driving data-plan usage with web-usage orders of magnitude higher than other smart phones.

The stock is reacting positively and is up about 4% from its 4:00PM close of $122.96.
AAPL also announced a special event on March 6 to discuss the plans for the long awaited SDK for the iPhone. The announcement emphasized ‘Some exciting enterprise feature’; ; perhaps referring to the long awaited integration with the Exchange server and the catalyst for the corporate adoption of the iPhone.

Google, the other Silicon Valley darling under cloud, will also be presenting at the Morgan Stanley Technology Conference in Dana Point, CA. The session is scheduled for 9:30 a.m. Pacific Time on Monday, March 3, 2008. If the response to AAPL’s conference call is any indication, it would be prudent to anyone short Google to cover!