Wednesday, November 28, 2007

This is it boys!

Freddie Mac's $6 billion preferred offering is supposedly going to yield between 8.5 and 9%. It has a five year call feature, after which it will become floating. So you might say the preferred will have a +500ish spread to the five-year, which is certainly expensive debt.

Now comes the moment of truth. See, Freddie Mac was always going to be able to get fresh capital. I'm highly skeptical of "too big to fail," but in Freddie's case, they are. So no one seriously doubted that Freddie could sell new preferred shares. The question was how difficult and expensive would it be? How would the market receive it? Would this market agree to fund what is in essence, one gigantic portfolio of subordinate mortgage credit.

So where does that leave other financial institutions looking for new capital? Consider that many domestic and foreign banks/insurance/other financials are suffering from mortgage-related losses of one type or another. Some, like Countrywide, Rescap, etc. have been singled out as in particular trouble. But many others really just need a capital infusion to absorb the losses and move on. We know Citi's already raised some cash (which really wasn't at 11%, but expensive none the less). I'd suspect many others to come forward looking for new capital: Washington Mutual, National City, AMBAC, MBIA just to name a few.

The key will be how the new Freddie preferred trades post issuance. It's a $6 billion deal, so its bound to attract a trading volume not normally associated with the preferred market. Will traders push it lower? If so, what kind of level would someone like AMBAC or MBIA have to pay to raise new capital? Maybe the price would be so high as to make it an untenable trade.

Conversely, will the high yield attract real money buyers? That would push the preferred price higher. And that would open the door for other banks to come to market at reasonable levels. Liquidity would improve. Spreads would normalize.

Bear markets don't end when the bad news ends. Bear markets end when prices reflect all the bad news. Usually when market prices reflect more than all the bad news. When confidence in the future improves. When the sellers of risk are exhausted and buyers of risk emerge. Freddie Mac's offering is a test of where we are in this bear market. If Freddie's preferred is beat up post sale, we've got a long road ahead of us. If it does well, then maybe this credit cycle will be short.

So we've locked our S-foils in attack position, and we're headed down the trench. Is this Death Star I or II?


Anonymous said...

My suspicion is that the same dynamic is driving this "credit cycle" that drove it up until now.

Up until now the belief was that housing would always appreciate.

Now, housing will always depreciate...with a longer and longer horizon.

In other words, welcome to Japan.

DAB said...

Remember also that Death Star was one of the Enron trading strategies out in the western markets back in the days of the california blackouts. Could it be that the metaphor gets more mixed and some of the off balance sheet jazz at the banks is far worse than is known?

venkat said...

Hi AI,
I know you have a more interesting post already which is eliciting more comments than this. :) However, I would really like to get your response on this. I don't know understand how CITI could do a deal with ADIA at such exorbitant terms. I have outlined my logic below. Pleas efeel free to correct me. I have deliberately ignored margin costs etc to keep the argument simple

When the deal happenned, Citi was trading around $31. ADIA has effectively bought 201m calls for 37.24 and sold 235m puts for 31.83 i.e. at the money Puts and out of money Calls for the same time period. Let us assume that ADIA funds CITI by short selling CITI's stock. It can shortsell 235 m Citi's stock today which provides around 7.5 b and use those proceeds to fund Citi's debt. ADIA does not have a problem if the share price goes below 31.83 after four years. It uses the mandatory stock that it receives from CITI and covers its position completely while enjoying 11% yield. Its only risk is that the share price can go above 37.24. What can ADIA do to hedge this risk? ADIA will have a neutral position by buying 34 m calls for 37.24. How much does buying these 34m calls cost? Buying the shares itself would cost around 1b. So I would assume the options would cost even less. This is ADIA's net Investment in this deal and it enjoys 11% yield on 7bn in return for four years. Who would not invest in this deal?

Accrued Interest said...

Venkat: I tried to answer you in another post.