The Financings of Last Resort, Part II

When I wrote my last piece, “The Financings of Last Resort,” I did meant to add that this will be a common phenomenon for a year or so. Pretend you are part of a senior management team of a credit-sensitive financial institution, and your worst nightmare is slowly unfolding in front of you. You’re looking looking at delinquency and loss statistics stratified by year of issuance (“vintage”) and time since issuance. Every vintage since 2003 looks worse than the prior year, and the loss seasoning curves are all pointed upward — in the early vintages, mildly, and in the 2006-2007 vintages, wildly.

You are seeing current losses come through, and they are erasing much of current profits, or, creating crushing losses if you try to get ahead of the loss curve and put in sufficient reserves to handle likely future losses. Any loan loss estimate toward the beginning of a “bust” phase is a wild guess, and management teams are often behind the curve as they hope that the most recent data point was a statistical fluke.

But management teams often think along two tracks. The first is the “best current estimate,” which they give to the market through GAAP accounting. The second is “What if things get bad, and we run short of capital? Better to get financing now, while our stock price is relatively high, and bond and preferred spreads low.”

That reasoning drives two types of capital raising — financings of last resort, and protective financing. That second class of financing was what I commented on at Felix Salmon’s blog regarding JP Morgan.  Borrow when you can, not when you have to.  Get in front of the loss curve, not behind it.

But, for those that are behind the curve, the financings of last resort are protective, at least for a little while, of management teams and bondholders.  Consider the actions at:

But who loses? Current stockholders get diluted.  I can imagine the management consoling their consciences with the thought, “Yes, the stockholders lose, but what would they get in bankruptcy if things got worse, and we didn’t raise capital?”

So, even if credit-sensitive financial companies avoid going broke, they may not be good equity investments because of the dilution.  I said that early on with the financial guarantors.  The big guys are still alive, but their stock prices are down significantly.  (Oh, and note that the regulators like this approach.  No public funds get used.  No embarrassing front page insolvency news.  “What was the regulator doing?”)

How long will this continue?  Financings of last resort can go on until the stockholders rebel and throw out management (hard to do), or the estimated net present value of the profit stream of the company is negative; no one will finance that.  (Think of ACA Capital Holdings, maybe.)  The nature of a financing of last resort is that the financier hands over cash in exchange for cheap equity that can be recycled into the market.  It’s a coercive way of doing an equity or debt offering, and requires a significant discount to current financing valuations.

So, how long will the bailouts go on?  I think for quite some time, which I why I am avoiding that area of the market.  Avoid the equity “fire sales” if you can.  Remember, management teams usually know more than the average analyst when it comes to knowing the true value of cash that can be generated from illiquid assets.  So when you see financial firms pursuing liquidity during a time of debt deflation, don’t be a hero — avoid those companies.