There was an interview in Barron’s over the weekend with PIMCO’s Mohamed El-Erian in which he prescribes to investors how to approach the troubled financials. Here is an excerpt:
Barron’s: What kind of noise do you hear now, and what is it telling you?
El-Erian: “We’re seeing two different realignments. The first is the return of inflation, with the rise of the world vis-à-vis the U.S., and an amazing rally in commodity prices. It’s amazing how quickly the rally occurred. These are reactions to fundamental changes.”
“We will also see new reactions to crisis management steps. This part isn’t in the book because I didn’t foresee the March 16 action by the Federal Reserve. [On March 16, the Fed helped arrange a sale of Bear Stearns to JPMorgan Chase, providing as much as $30 billion in financing for Bear’s less-liquid assets such as mortgage securities. In addition, the Fed allowed securities dealers to borrow from the central bank under terms normally reserved for regulated banks.] Opening up the financing window for investment banks is going to realign the financial system as we know it.”
“First, it will be very difficult for the Fed to withdraw the window once it’s introduced. What’s temporary will become permanent.”
“Second, once the window is permanent, these institutions will be subject to greater regulations aimed at de-risking. If you’re a senior bondholder, you’ll do well, and if you are an equity holder, you’ll be diluted, because A) the institution is going to be issuing more capital and B) the return on equity is going to come down. That action has very different implications depending on where you are in the capital structure.”
“Third, these de-risked institutions are going to look for deposits as cheap funding. That will cause a wave of mergers and acquisitions in the financial system as they look for small commercial banks they can buy. If they are going to be regulated like commercial banks, they will try to benefit from what commercial banks have, which is access to cheap funding. You will see some alternative institutions — hedge funds, private equity saying, ‘Wait a minute, why don’t we move into the space vacated by the investment banks?’ The sovereign wealth funds have played a critical role; some $69 billion of pure capital came from such funds into the Western financial system. In the future they’ll be important providers of recapitalization because they know the sector well. The problem is they are going to hit limits: They can’t acquire more than 9.9%.”
So what does this mean for investors?
“If you are a bond holder, you want to be ahead of a recapitalization. If you are an equity holder, you always want to come in after. When people have been pushing the financial sector, they haven’t made the distinction between what is good for the bondholder and what is good for the equity holder. The equity holder wanted to buy emerging markets after they recapitalized in the late 1990s, U.S. corporates after they recapitalized in 2002 and 2003 on the back of Enron, WorldCom, etc. The timing is critical. For the bondholder, it’s the other way around because a recapitalization lowers risk and therefore brings in spreads. And the people who are diluted are equity holders.”
El-Erian has hit the nail on its head. The debt of large-cap financials are starting to look attractive because the Fed has set a precedent that it would bail out the creditors of any bank larger than Bear Stearns due to risk of a systemic financial collapse. I’m not buying any debt instruments because I’m worried about inflation in the long run, however, there could be an attractive medium-term trade.
I am shorting financial stocks and selling out of the money call options on them for the exact same reason El-Erian states. Banks are going to come under greater regulation in an attempt to ensure stability and they will be forced to raise a lot more money to strengthen up their balance sheets which would significantly dilute shareholders.
Another well-reasoned idea El-Erian puts forth is that investment banks are going to look at deposits as a cheap source of funding. Their targets will most likely be small regional banks that were conservatively managed with growing deposits. If the sell-off continues, I plan to look for attractive investments in this space.