Long WM 5 3/8% pref / Short common stock as hedge.
Key Points
- 5 3/8% preferred has a good position in capital structure. It is senior to $14bn of tangible equity and $7bn of preferreds. Note that the 5 3/8% are senior to the $3bn of 7% conv prefs the company issued late last year. The conversion price is $41, so this is way out of the money. At $30 price (vs $50 par), these yield 9%.
- WM has a lot of exposure to bad loans. 76% of loan book is residential mortgages and another 17% is in other real estate loans. ~50% of total residential mortgage loan book is in CA. Of total $190bn of residential mortgages, it has $19bn subprime loans, $45bn home equity 2nds, $58bn of option ARMs, all of which is against only $14bn of tangible equity.
- Common equity has downside given likely equity raise. Despite the risky exposures described above, WM only had ~100bps of loan loss allowances against its loan book as of 12/31/07. Thus, WM will take loan loss provisions of $10-12bn this year. A provision of this size could require the company to raise $3+ bn of capital, which is >30% of current market cap.
- Additional capital will come in below 5 3/8% preferreds, which helps credit position. Rating agencies won't give equity credit to anything issued at or above 5 3/8%, so new capital will come in below this issue.
- WM's branch and deposit base has strategic value. WM has 2,200 branches in 15 states, including top deposit shares in fast growing western states (#3 CA, # 2 NV, #2 WA, #5 AZ). WM is the only sizable entry ticket for a large bank to gain a western US deposit base. JPM is said to be interested as they dont have a presence in these states.
Potential Payoffs
- Base case: Company raises enough equity to get through credit problems. Credit stabilizes and the pref trades at T+300bps, which is $38 (27% upside). If this happens in two years, you get 13% annualized appreciation +9% dividend for 22% total IRR.
- Upside/Takeout case: JPM or another big bank buys WM for deposit footprint. If its a cash deal, 5 3/8% pref will get par put so will be worth $50 (67% upside). If its a stock deal, 5 3/8% prefs will trade to JPM's credit so I estimate T+150bps which is $46 target (53% upside). Obviously, the take-out price will affect what happens to short common. I think a big premium deal is highly unlikely given the credit issues and undercapitalization. A low premium or take-under is much more likely, which would be very good for this position.
- Downside case: credit continues to deteriorate and 5 3/8% trades to T+700, which would put this at $24 (20% downside). In this scenario, common would trade down significantly and offset some of the loss.
How to hedge?
Admittedly more art than science, especially given the volatility of the common. I would suggest anywhere from 30-50% as a starting point, but you definitely have to have a directional view on the equity.
Catalyst
Q1 earnings could see big provision increase, leading to a new round of capital raise which could be downside catalyst for the stock. This will also put preferred in better credit position, which should ultimately cause spreads to tighten.
Takeout by large bank (eg JPM) would be upside catalyst for prefered. WM has a very strategic footprint, and JPM clearly has an appetitite for distressed assets on the cheap (BSC).