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Financials Use Artificial Rally to Issue Real Equity


"Stress test" just another term for "short squeeze."

Not surprisingly, and very wisely, it isn't just banks raising equity these days. I'm not the biggest fan of Tim Geithner, but I'm starting to think he's a heck of a trader. Some of the biggest shots around would've been proud to have engineered his short-squeeze (formally known as a "stress test"), into which banks like Wells Fargo (WFC) and Capital One (COF) have been selling. Geithner seems to have understood the performance anxiety he could generate, and to have taken full advantage. Frankly, he deserves a lot of credit for pulling it off.

Okay, let me stop digressing. Smart companies (like Bank of New York (BK) and Morgan Stanley (MS)) are taking advantage of this arguably artificial rally to raise equity without difficulty. A couple of months ago, some of these firms might not have been able to sell stock at any price, let alone today's prices. It's yet another testament to the power of like-minded thinking by portfolio managers: I'll buy it if you're buying it, but not otherwise. (Now comes another shameless plug for my upcoming book, The Undoing of Cowardice, which talks about this tendency and suggests ways for investors to recognize and profit from it.)

When companies issue new equity, it's a 2-run homer for convertible arbitrageurs. Convertible arbitrageurs are long bonds and short stock. The issuer's credit quality has clearly improved (with the added equity cushion improving the first line of defense against losses, shielding bondholders) and the stock goes down. Good for the long, bad for the short.

When convertibles are highly equity-sensitive and the underlying stocks are well above the conversion prices, new equity offerings don't matter much, because the convertibles essentially are acting like stock already. But when credit quality is an issue -- as it is, as a very general rule, for convertibles trading at or below par value -- new equity issues are a very big deal. And even with the recent run-up in stocks, almost all convertibles (other than those issued in the last couple of months) are still trading well below par.

I'd expect the spate of equity issuance to continue. Not only are corporate financial managers subject to some of the same "me, too" mindset as professional investors, but it happens to be a really good idea. It isn't every day the Secretary of the Treasury engineers a giant short-squeeze that lifts the weakest stocks the most. Issuing stock now is sort of like playing a "Get Out of Jail Free" card. And convertible holders will be prime beneficiaries.
No positions in stocks mentioned.

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