Distressed Bank's Capital Destructive Debt Issuance

By: Mike_Shedlock

Minyan Peter was back posting on Minyanville today after a 3 week hiatus. Peter is a former treasurer for a large Midwest bank and one of the brightest minds you can find anywhere. From Peter: I am finally back from three weeks away from the markets and would offer two quick thoughts from Europe.

First, if you think the US consumer is struggling, go there. Between energy and food inflation, not just dollar denominated, but even Euro denominated prices were out of this world. I don't know how many people we talked to who shared that they can no longer afford to go out for dinner. And having spent $100 for a pizza dinner for four, I certainly understand.

Second, Russia's invasion of Georgia was generating a whole lot more buzz there than here. And understandably. With Europe's dependence on Russian energy many questioned how effective their response could/would be. At the same time the historical parallels were deeply troubling. Finally, many were surprised that most American's did not realize that Georgia was right next to NATO-critical ally Turkey.

Finally, a real time thought: Beyond credit card loans, when you are raising senior debt at 6.5%, as Citigroup (C) did yesterday with it's $3 billion senior debt issue, I am not sure what you can finance with a positive spread in today's market. Regrettably, the days of capital destructive debt issuance have begun.

Banks remain exposed to risk after debt sales

The new game in town is getting any deals done at any price. The best example to date is Merrill Lynch (MER) selling CDOs for a reported 22.5 cents on the dollar. What Merrill really got was 5.5 cents on the dollar. Merrill may (or may not) get more later, up to a maximum of 22.5 cents on the dollar.

It's not just Merrill Lynch in these kind of deals. The Financial Times is reporting Banks remain exposed to risk after debt sales .
Citigroup and Deutsche Bank are still retaining some of the risk from billions of dollars in loans backing leveraged buy-out deals that they have sold in recent months to private equity firms, according to securities filings and bank officials.

The sales were cheered by the investors as a sign the banks were cleaning up their balance sheets. But the banks' remaining exposure to the loans is less well understood, in part, because of the lack of public disclosure.

This year, banks including Citi, Deutsche and Royal Bank of Scotland have sold $25-30bn in buy-out loans to three private equity firms – Apollo; Blackstone, through its GSO Capital arm; and TPG.

The banks generally sold the loans at a price of about 85 cents on the dollar, people familiar with the deals said. The banks also granted the buyers new loans – at below market rates – to help them buy the old loans. The new loans amount to about 80 cents for each dollar of old loans bought.

If the old loans drop in value, the deals are structured so that the private equity firms take the first losses, up to about 20 cents on the dollar. If the old loans fall further – as could be the case in a severe economic downturn – the banks could suffer additional losses on the loans they “sold”.

In a regulatory filing, Citi said its loan sales “substantially mitigate the company's risk related to these transferred loans”, implying it retained some risk. The bank said it hedged retained risk by buying derivatives called total-return swaps but it declined to say how much it has paid for the instruments.

Analysts say such hedges can be expensive – sometimes costing more than the position being hedged. They say banks can be willing to pay so much because it is easier to tell shareholders they spent money on hedges than to report loan losses.

Very Expensive Deals

These are very expensive deals and they are not even raising much capital. However, the name of the game now is to get any deal done while deals still can be done. Wachovia (WB) bounced from $7.80 to $19.49 in the SEC sponsored short squeeze. It was a golden opportunity to raise capital by selling equity. I talked about this yesterday in Can Wachovia Do Anything Right?

Wachovia has been giving back those gains for several days now. Today it is off another 7.4% to $14.81. And the longer Wachovia waits to raise capital, the more likely it is for its share price to sink. So as distasteful as these asset selling, capital destructive deals are, the sad truth is they are a better option than doing nothing and taking even bigger losses later.

By Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

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Mike Shedlock / Mish is a registered investment advisor representative for SitkaPacific Capital Management . Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.

Visit Sitka Pacific's Account Management Page to learn more about wealth management and capital preservation strategies of Sitka Pacific.

I do weekly podcasts every Thursday on HoweStreet and a brief 7 minute segment on Saturday on CKNW AM 980 in Vancouver.

When not writing about stocks or the economy I spends a great deal of time on photography and in the garden. I have over 80 magazine and book cover credits. Some of my Wisconsin and gardening images can be seen at MichaelShedlock.com .

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