Option ARMageddon » Blog Archive

Capital Raising

March 12, 2008 – 10:59 pm

Banks are strapped for cash. This much is obvious. Ways to shore up capital levels on a financial institution’s balance sheet fall into two categories that I can think of. Bring it in and don’t let it go. Ways to bring in new capital include infusions from sovereign wealth funds for example or making margin calls on stretched borrowers. Ways to keep existing capital on the balance sheet include not making new loans, cutting dividend payments to shareholders.

In his speech announcing the Bush administration’s new regulatory proposals for various financial institutions tomorrow, Treasury Secy Paulson is expected to encourage those institutions to take a fresh look at their “dividend policies.” He’d rather they conserve that capital so they can “continue to lend….”

The blog Financial Crookery recently noted that Merrill unilaterally sweetened the deal on one of its convertible issues in order to avoid a capital draining event. (Hat tip Laurito)

Give ‘em points for creativity:

NEW YORK, March 6, 2008 — Merrill Lynch & Co., Inc. (NYSE: MER) announced today that it has amended the terms of its Exchange Liquid Yield Option^™ Notes due 2032…to increase the conversion rate from 14.0915 to 16.5000 [and] to add September 13, 2010, and March 13, 2014, as dates in addition to the existing dates on which holders may require Merrill Lynch to repurchase all or a portion of their LYONs….

To understand why this is a clever way to dodge a drain of capital on the balance sheet, you have to have a basic understanding of convertible bonds. In its most basic form, a bond is just an IOU. A borrower sells the IOU to a lender in exchange for interest payments on the amount lent.

A convertible bond has an added feature. It gives the lender an option to convert the bond into common stock at a certain price. This particular bond has a “conversion rate” of 14.0915. That means every $1000 worth of bonds is convertible into 14.0915 shares of Merrill stock. The “conversion price” of the stock is simply the price at which conversion takes place: $1000 divided by 14.0915 shares = $70.96 per share. If Merrill common stock is trading above $70.96, I can convert my bonds to stock and recognize an instant paper gain. If it’s trading below that level, then converting my shares to stock would result in an instant loss.

Essentially, a convertible issue is a bond packaged with a call option. It’s a safer way to play a stock because while the bond’s value will increase as the stock increases, it won’t necessarily decline as the stock declines. The stock can fall precipitously, but the convertible bond is still worth its par value at some date in the future…..assuming, of course, the borrower has the capital to pay back bondholders when the bond comes due…..

Here’s a handy chart that illustrates how a convertible bond’s value relates to the value of the stock it can be converted into:

You can see that as the “current stock price” increases (as we move along the X-axis from left to right), the value of the convertible bond converges with the value of the stock. But as the stock price decreases, the value of the convert converges with the value of the bond. Upside without the downside.

With a basic understanding of converts, it’s easier to appreciate Merrill’s trickery.

The only other thing to know is that the issue mentioned in the press release has another key feature: it is “putable,” which means bondholders can “put” the bond back to Merrill at par on particular dates. One of those dates is today, March 13. With Merrill stock at $44, the call option embedded in the bond has little value (I’m guessing the over-under on Merrill stock getting back to $70.96 is probably 2011…;). So bondholders have an incentive to “put” their bonds back to Merrill at par value in exchange for cash.

Merrill would prefer that cash NOT drain from its balance sheet right about now. It would rather bondholders hold onto their converts until which time they can be converted profitably into common stock. In that case Merrill wouldn’t have to shell out any cash….only more stock certificates.

So to give investors an incentive to hold onto their bonds, Merrill unilaterally increased the conversion ratio to 16.5 shares from 14.0915 shares per $1000. That means bondholders can now convert their bonds into equity at $60.61 per share on the common ($1000 / 16.5 shares = $60.61 per share). They’re also giving bondholders two more dates on which they can put their bonds back: 9.13.10 and 3.13.14.

Financial Crookery puts it well: “Merrill gets nothing in return for these new features, they are unilaterally value-enhancing for the bonds. The bonds’ fair value is now presumably sufficiently above [this] week’s put strike that bondholders will not exercise. Cash call avoided, at least for now.”

Cash is king.