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Has the Financing Window Shut?


Brokerage firms should be allowed to fail.


The biggest question on my mind these days is who will try to go to the financing window and find that the window is shut? Up until now, deals have been getting done at increasingly higher rates, which are, of course, less and less economic.

What could be the worst scenario possible? I think it could be when 1) your industry is down, 2) you need to de-lever your balance sheet, 3) the quality of your balance sheet is deteriorating and 4) the economy is slowing, not to mention increasing inflation.

When I think of the "poster child" for this ugly scenario, I come up with Lehman Brothers (LEH) and Utah-based Zions Bancorp. (ZION). Lehman's balance sheet is littered with leverage loans gone bad, tons or poorly performing commercial real estate loans and Level 3 Assets at nearly three times shareholder equity. Further, the traditional business lines it's used to operating in are dead.

The biggest issue as a broker/dealer is counter-party risk and confidence from those you trade with, something I wrote about a few months back. As an ex-Drexel Burnham Lambert employee, I know what it's like to have confidence lost in your firm and what it feels like for counter parties to not take your phone calls. Many brokerage firms and banks have gone to the "hybrid" (fixed rate for a period then floating rates, otherwise known as "fixed to floating") window in a big way. So big, in fact, that when Standard and Poor's downgraded many brokers recently, it highlighted the fact that most firms have already hit the ceiling on how much they can offer.

But what about the preferred stock market? I did a screening on Bloomberg just now that reveals all of the listed investment grade preferred stocks that are currently yielding north of 9%. The list is littered with those that I think will have trouble financing themselves. Since these companies cannot offer hybrids, and are attempting to de-lever, they will likely attempt go to the equity window or the preferred stock window.

But what rate would these impaired banks and investment banks have to pay to get access to capital? In most cases, (like Lehman, Merrill Lynch (MER), Morgan Stanley (MS), Citigroup (C), Zions, Regions Bank (RF), KeyCorp (KEY), etc.) they would likely have to pay a "premium" to where their outstanding preferred shares are trading, say, something in the 10-11% range. Given the impaired nature of their balance sheets, 10-11% cost of capital makes it pretty hard to make a positive net margin on their existing business lines.

The other question is who will buy these new issues?

While I've stayed clear of credit risk (except for the short side of credit risk) for many years, even 10-11% would not entice me to buy them. Retail investors have been jammed full of these issues and would likely not buy either. Which leaves insurance companies (who are being forced to issue themselves at 9+% rates) or the Pimco's of the world, which are likely jammed full as well.

There have been two recent transactions that caught my eye and make me believe we are at the doorstep at which point new issue deals stop getting done. Prudential Financial (PRU) floated a relatively small, $250 million preferred deal at 9%: It was not well received and immediately traded below par, where it remains. Next was Zions "attempting" to self-underwrite a 9.5% preferred deal, which is yet to have been sold.

If the companies are unsuccessful at raising new capital, many of them, especially Lehman will end up in the arms of a well-healed suitor, a la the JPMorgan (JPM)/Bear deal, or simply disappear.

I know this may sound draconian, but I took a straw poll here on Minyanville the other day and asked investors what rate they would demand to lend money to Merrill or Lehman. The answer, for the most part was, "There is no rate high enough." This is troubling but something I've anticipated for quite some time and what keeps me so cautious.

In short, I'm on the lookout for a wave of deals that are floated and that do not get completed. I believe that Stage 2 of the Credit Crisis is upon us and is being triggered by the market waking up and realizing that many of the largest fianancial concerns are insolvent and will either a) merge into some other entity at a huge discount to current prices, b) dilute current equity holders to the point that earnings wil disapear altogether or c) simply go away.

Frankly, I don't think the Fed really wants them to all go under. Under a free market (with no government intervention), they would face bankruptcy or take-unders because they imprudently sold bonds to investors, were reckless with their own capital and had no concern for their clients. But I imagine the Fed doesn't want this to happen and we will see a bit of a, b and c. One thing is for sure, it will not be pretty. I remain cautious and believe risks remain as high as ever.

To drive the point home a bit further, it is no coinidence that these firms have 1) written off the most capital 2) laid off the most workers, and 3) have the greatest amount of Level 3 assets. None of this inspires confidence.

In summary, I do not see a way out for many of them. The case in point was when Lehman told the market that it didn't need to take write-downs and didn't need to raise equity. The week after this announcement it fired its CFO and raised capital it said it didn't need, in order to pay for write-downs it said it didn't have. It shows the company's inability to assess risk.

I really wonder why firms should get bailed out for that sort of behavior or be allowed to go to the Fed Discount Window. They should be allowed to fail. Period.

For further consideration, please consider the following lists:

Position in ZION options

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