A Huge If: S&P to Rally If Financials Hold
September 14th, 2008 by 
James Cullen
I came across this call by David Kostin, Goldman Sachs’ (GS) Chief US Portfolio Strategist, in which he says the S&P 500 could have 12% upside to 1,400 by year-end. This part in particular caught my eye:
Bullish signpost to watch for: (a) Moderation of losses and successful capital raisings for S&P 500 Financials; (b) Steps taken to resolve the GSE crisis; and, (c) Pockets of stability in housing. Key downside risks: (a) A significant, negative event in the Financials sector; (b) Evidence of a global recession; and (c) Unexpected negative US macro news.
The idea that capital raises by major financial firms will go a long way toward dispelling rumors and realization of chaos is not new. But a key component of any successful capital raise is that the deal would have to be done at a reasonable cost to the issuing institution. I’m finishing up a presentation on the market outlook for the BC Investment Club, and one of my leading concerns (besides the obvious difficulty of raising capital) is the costliness of any financing that might be obtained.
As was noted in mid-August, even traditionally well-regarded financial firms like Citigroup (C), American Express (AXP), and AIG have to offer paper at huge spreads (risk premiums) to Treasuries. Citigroup priced a deal at Treasuries + 300 bps, American Express at Treasuries + 400 bps, and AIG at Treasuries + 475 bps. Wells Fargo (WFC) did a five-year callable preferred offering at Treasuries + 550 bps, and CFO Howard Atkins seemed happy just to have gotten the deal placed, noting that at least Wells still has access to the capital markets.
Of course, these kind of spreads are becoming systemic as this chart (from before the magnitude of Lehman’s troubles became known) shows:
But, of course, there is the huge caveat that Kostin added – namely, “a significant, negative event” involving one or more financial companies. And it now looks like that is set to happen, given that Bloomberg is reporting both Barclay’s (BCS) and Bank of America (BAC) seem unwilling to make a deal for Lehman (LEH). In a special Sunday trading session predicated on a Lehman bankruptcy filing later today, an index of credit default swap spreads was up 35% since the close on Friday, to a level surpassing what the index hit in mid-March during the Bear Stearns drama.
Personally, I’m a bit nervous about the impact this could have on Primus Guaranty (PRS) and their credit default swap book – it looks like the Fannie/Freddie obligations Primus wrote swaps on will be fine (they’re trading at or above par, thanks to the government backing) – but the specific exposures to Lehman are unknown, as are any ripple effects this could set off.
Conversely, some have argued it’s possible that Lehman can fail without creating some sort of systemic meltdown – and if that were to be true, the market could rally as Kostin predicts. An orderly runoff would likely wipe out the common stockholders, but it is impossible to say how far the pain would spread up through the capital structure, or how long it would take for that scenario to play out. For what it’s worth, Lehman’s long-term borrowings consist of $110.5 billion in senior notes, $12.6 billion in subordinated notes, and $5 billion in junior subordinated notes, as well as $7 billion in preferred stock.
Given not only the enormous degree of uncertainty, but the magnitude of importance a resolution to that uncertainty will have, it seems foolish to take this as a classic “buy fear” moment unless an identifiable, company-specific edge exists.
Kostin’s second possible risk scenario – a global slowdown – has gained momentum of late, and that is tomorrow’s topic.
Image Credit: Bespoke.
See more AIG, AXP, BAC, BCS, C, Financials, GS, James Cullen, LEH, Stock Market, WFC | 
September 14th, 2008 at 9:13 pm
right before I opened this, I that BAC is buying MER for $44b, a ~75% premium over Friday’s close.
If LEH is resolved well overnight, it looks like financials could have a good day/week/future.
September 14th, 2008 at 10:19 pm
I think PRS is limited to 15% of capital to any one name (Lehman) so hopefully this will not kill them. Not sure on counterparty risk though, ie if Lehman bought a bunch of protection on other notionals, could impact PRS future revenue stream?
Could have some gut wrenching moments looking into the abyss - eg if PRS immediately falls to 2.50 or something - is it a great buy or does someone know something that I dont????
September 14th, 2008 at 11:48 pm
You’re correct about the 15% maximum to Lehman, which is a Moody’s A-rated company… the limits are dependent on ratings, so something like Baa is 10%, etc.
By my math, that would be $130 million in gross notional. Even with zero recovery, that’s only two quarters worth of losses relative to my run-off model.
I’m fully expecting to be down 20%+ tomorrow on a mark-to-market basis, but I’m looking for dry powder. Things are going to break fast, so we’ll just have to see what goes on…
September 15th, 2008 at 1:06 am
One interesting question - what is Lehman? By that I mean, is it Financial Intermediary, or is it a “Broker/Dealer/Investment House” Looking at their categorization, there is about 2.5% of portfolio to the latter vs the 13% we keep mentioning to the former. Then there is 10% out to “Insurance” so I assume we also need to keep our eyes on AIG…..
If for some reason LEH is part of the B/D/IH above then we could get comfort that the exposure might be even less.
I also would find that dry powder if I were you, wish I hadn’t bought that PRD in the 9s last week but hindsight is always 20/20. And while CNBC doesn’t know it all certainly, there was a text flash talking about estimated bondholder recoveries of 60-80%…….
Thank goodness these guys have a decent amount of cash etc on the books…..it is looking more likely they’re going to have to use some of it…..
September 15th, 2008 at 1:23 am
Hogan,
Huge catch - I know I’ve asked that question about what constitutes a “financial intermediary” of Primus previously, but I don’t remember a clear enough answer to want to say something inaccurate here.
Saw the 60-80% recovery rate, which would give a net loss of $50 million if Primus was maxed out and saw a 60% recovery - hardly catastrophic. I might sit up all night waiting for the stock (not to mention the more illiquid debt) to get whacked though… I need my own Primary Dealer Credit Facility.
September 15th, 2008 at 1:33 am
Yes tomorrow will be interesting to say the least. Wonder if we will see levels at, or below, July 15. Question will be whether to wait and watch it, or even wait till we get the inevitable press release from Jasper, or to pounce on some low prices. We’ve got AIG, Wamu, and lord knows how many other chumps out there circling the foggy airport running low on fuel. PRS can absorb a few of these, but not too many. Although even just one or two big hits could probably knock its AAA rating and basically push it into runoff mode (although in many ways its in runoff mode already since it isnt writing any material amounts of new business)
September 15th, 2008 at 3:25 am
I commented on one of the posts here a couple weeks back that the market was looking very ugly because there wasn’t any sustained leadership. This is, in my experience (which, granted, only includes one period like this one, the tech bust), a sign that the market was approaching a major bottom.
The sign that the bottom was approaching in the tech bust (clear in retrospect) was when being atop the IBD 100 was a death warrant for a stock. Week after week, the top momentum plays were taken out and shot, because the market was unable to sustain any leadership. It was when there was no place to make money in momentum that allowed enough pessimism to take hold in the market for us to finally bottom. Also, just on a calendar basis, we are entering the time of year that bottoms are formed. Now, it could be that we are entering financial catastrophe. But, that’s the fear that’s going to be necessary for us to reach a level to make a bottom. I’m buying any big move down this week, although I’m not buying financials, just because I’m not smart enough to know which is safe and which is not.
September 15th, 2008 at 12:22 pm
I am surprised at the slow speed at which PRS is selling off - it has taken several hours. I was somewhat surprised to see it sitting there in the mid 4s first thing this morning - might consider selling my bits of PRS and wait to upgrade to some more PRD at a lower price, but then I am being emotional….
September 15th, 2008 at 4:23 pm
It appeared PRS found a pretty hard floor at 3.00 - someone seemed to be supporting it at that level??? The fall to 3.00 was pretty steady thru the day but once it hit 3 it basically just stayed there. Which party(s) would be supporting it at this level?
September 15th, 2008 at 6:55 pm
80mm gross exposure guys - not as bad as feared - let’s hope those recoveries are more like 60 cents or more, but…..
Now we wait and watch AIG, and Wamu, and Wachovia, and whatever other names out there percolating
September 15th, 2008 at 9:45 pm
Hogan,
Not sure what happened at $3, but it definitely got buyer interest…
As for the Lehman exposure, should the 60% recovery hold, we’d be looking at $32 million in net losses. This is completely manageable; my realized allowable credit losses for this quarter is about twice that… so while I don’t want to say “bring it on” to WaMu, AIG, and Wachovia, this hit alone won’t sink the ship.
September 15th, 2008 at 11:39 pm
WaMu was recently BBB and now BB, so its max % should only be 5% of capital now (assuming I am understanding correctly that it is an ongoing test) - and AIG is now A so perhaps that max is somewhere around Lehman’s - $80mm. I assume Jasper and Co have been conservative and not run up to the max limits - that appears to be the case for the Lehman piece at least.
September 16th, 2008 at 10:18 am
So much for $3, and for any risk-adjusted return awards I might win.
September 16th, 2008 at 11:29 am
Man oh man - was just a little too slow to hit that 5.50 on PRD - now can get some in the low 6s though - 5.50 is juicy (then again I was congratulating myself for picking it up in the 9s last week - my timing is impeccable!) Ask me tomorrow after AIG files and PRD is trading at 3.75 though.
Like the old song says, going down in a blaze of glory. I will either end up making a boatload here, or have a nice hickey to show for my experience in tangling with the 1000 year hurricane.
September 25th, 2008 at 10:16 pm
WaMu - does the Federal seizure of Wamu today constitute a default for Primus’ purposes?
September 27th, 2008 at 9:49 am
Hogan,
Primus filed an 8-K last evening saying that their notional exposure to WaMu is $16 million.
December 6th, 2008 at 6:21 pm
[...] "market gurus" are, and where I’m at. The last time I did this was in mid-September in the days of S&P 1,250, and it made me realize just how bad the macro environment was becoming, and how little was being [...]
December 6th, 2008 at 7:16 pm
[...] "market gurus" are, and where I’m at. The last time I did this was in mid-September in the days of S&P 1,250, and it made me realize just how bad the macro environment was becoming, and how little was being [...]