It has a wonderful brand name and footprint in the investment banking space, but you need capital to survive in the industry, and with the write downs I expect in coming quarters, many of these firms will have a huge need for capital just to remain viable.

Some statistics on another potential bad bank:

• Wrote down book value from $35 billion to $31 billion or from $32.67 per share to $28.56 per share.
  
• Increased long term borrowings from $127 billion to $160 billion.
  
• Increased total debt to common equity to 2496.53%.
  
• Maintains an $88 billion position in Level 3 assets, or 283% percent of shareholder equity.

Who is this firm? Morgan Stanley (MS). Again, these numbers seem tragic to me when I consider what would happen if the company was actually forced to write down its "hard to price, hard to sell" assets.

There are only two solutions in my mind for what can happen to these firms. They can raise capital or sell themselves, perhaps for not very much. The capital raises I foresee in the second quarter might be something for the record books. Fannie Mae (FNM) and Freddie Mac (FRE) may need to raise up to $20 billion this year through a combination of preferred, convertible preferred stock and equity to get their financial ratios into OFHEO compliance, as they are being asked to pick up the slack of the hundreds of mortgage lenders that have gone bad and the commercial banks that are now backing away from lending. I just read a news story where UBS (UBS) may need to raise upwards of $16 billion. Merrill, BankAmerica (BAC), Wachovia (WB), Morgan Stanley, HSBC (owner of Household Finance), and many others will not be far behind.

How long will market participants be available to buy all of this new paper? My general take is not for long. While the Fed takes rates closer to zero, most large preferred stock deals have remained in the 8% area. If Merrill et al needs to raise upwards of $100 billion just to remain solvent, what rate would I pay for this paper? I hate to say it, but it would be somewhere north of 10% and as high as 12-15%. I just don’t see the value when I can buy Fannie/Freddie paper at 8 ½%. And what happens if they have to pay that rate? Profitability shrinks. In other words, the credit unwinding is like watching a train wreck in slow motion.

There are other bad banks, such as CIT (CIT), a global and consumer finance company that is slowly eating away at its capital base. It's in so much trouble that it recently had to draw down a $7 billion credit line just to avoid insolvency. It might fit very well into the likes of a GECC. Again, common shareholders may not like the price but it could be a great big/bank fit.

Another bad bank might be Cleveland-based National City Corp (NCC). It's recently been forced to pay 12% in a corporate debt offering and nearly 10% in a preferred stock offering. Rumors circulate almost daily about an imminent buyout, but if you were a buyer, would you really want to buy a bank that has HELOCs (home equity letter of credit) on homes in industrial states such as Ohio and Michigan and in the previously hot states of Florida and Nevada?

Not to mention all of the smaller, regional and community banks that based their lending model around real estate based loans. So you see, the problem is much more pervasive than many think. Then there is FGIC, which was just downgraded to junk bond status the other day. I am sure Ambac (ABK) and MBIA (MBI) are not far behind as their models are hopelessly broken. They had perfectly good business models until greed took over. I think they will all just disappear.

OK. All of this is rather sobering, so the real question becomes how does one take advantage of these opportunities? For quite a long time, my firm was long GSE preferred equity and short preferred equities of broker/dealers, particularly Bear, Lehman and Merrill. But two weeks ago, when the shotgun wedding of JPM/Bear finished and rumors began circulating about Lehman’s solvency, I removed all short side bets against the brokers and shrunk the long position in Fannie/Freddie.

Since that time, however, I have initiated short positions in preferred shares in the ‘not-so-good’ banks, like Wachovia, Wells Fargo (WFC), etc. It seems ludicrous to me that we can buy Agency preferred shares with a ‘tax equivalent yield’ around 11.5% and short preferred of Wells Fargo that are fully taxable and yielded barely 7.2% at the time the trade was initiated.  

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