Wachovia/Wells Fargo WB-Pref
December 31, 2008 - 2:42pm EST by
brook1001
2008 2009
Price: 18.40 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 800 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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Description

Make 30% arb’ing the difference between NYSE-listed Wachovia preferred shares and Wells Fargo preferred shares. Wells Fargo is acquiring Wachovia to make the largest bank in the US. The deal closes tomorrow and has already been approved by shareholders, so deal risk is nil. The trade is to go long Wachovia 6.375% Trust Preferred IX (“WB pref”) and short Wells Fargo 7.0% Trust Preferred IV (“WFC pref”). Both issues are technically junior sub debt. Alternatively, you can just go long the WB pref since there is limited borrow on the WFC pref, and because I believe the WB pref is very safe for reasons below. Both securities trade on the NYSE and have a $25 par value. The tickers are “WB C” and “WSF”.

The WB pref trades at an 8.7% yield to maturity while the WFC pref trades at a 7.1% YTM. The terms of the two securities are substantially similar and they will rank pari passu following the close of the deal. To be clear, the holding companies of WFC and WB will be merged and the WB security will become an obligation of WFC, so it will not be structurally subordinated to the WFC pref. The opportunity exists because there is widespread dislocation in the market for bank preferred stocks following the failures of Lehman, the GSEs and AIG, which wiped out $10’s of billions of preferred. Similar arb opportunities exist between the preferred shares of other bank targets and acquirers. For example, I posted the CFC pref arb in October, although the arb spread has largely collapsed since then. I don’t think the arb spread will close tomorrow when the deal closes, rather it should close over time as people realize that the WB pref is the same as the WFC pref.

As the exhibit shows, if you assume the WB pref trades to the same yield as the WFC pref over one year, you make 31% on the long side. If you are long and short, so that you are 100% hedged, you make 20% in a year on an un-levered basis. I think it is safe to just take the long side of the trade because the WB pref is almost as safe as a government obligation. This is a very strong statement. My rationale is:

1.    The WB pref is senior to the $25 bn of preferred that the government just invested in WFC. The government preferred is straight preferred, while the WB pref is technically junior sub debt. Therefore it is senior to the government; if the WB pref is not getting paid its coupon, the government cannot get paid its dividend. I think there is very little chance that the government will let the largest bank in the country defer dividends on the government’s investment given the negative political and economic fall-out that would occur. Instead, the government will fund WFC as much as possible to keep it solvent just as the government did by injecting a second $20 bn round of preferred into Citigroup last month and agreeing to insure $300bn of its assets. 

2.    The government is making a massive effort to support the largest banks including the $250 bn of TARP preferred investments, guaranteeing new debt issuance by banks, raising the deposit insurance cap, funding the purchase of ABS, and buying MBS and commercial paper outright, etc. I believe that WFC faces huge losses from its own residential loan portfolio, as well as the portfolio it is acquiring from WB, which will severely strain its capital ratios. But, I also believe that, if WFC needs capital, the government will stand ready to inject either additional preferred or even common equity, both of which would be junior to the WB pref and provide additional security.      

 

Long WB /Short WFC

Disaster

Down

Base

Up

Profit on Trade:

 

 

 

 

 Long 1 WB 6.375 (IX)

    (18.40)

       3.00

       5.76

       7.44

 Short 1 WFC 7.0 (IV)

     24.64

       0.57

      (1.99)

      (3.44)

 P&L

       6.24

       3.57

       3.77

       4.00

% return on WB 6.375

34%

19%

20%

22%

WB 6.375 (IX)

 

Disaster

Down

Base

Up

Yield to Maturity Target

8.10%

7.10%

6.60%

Implied Price in 1 Year

-

19.81

22.57

24.25

1 Year of Coupon

-

1.59

1.59

1.59

Current Price

(18.40)

(18.40)

(18.40)

(18.40)

P/L $

(18.40)

3.00

5.76

7.44

P/L %

(100%)

16%

31%

40%

WFC 7.0 (IV)

 

Disaster

Down

Base

Up

Yield to Maturity Target

8.10%

7.10%

6.60%

Implied Price in 1 Year

-

22.32

24.88

26.33

1 Year of Coupon

-

1.75

1.75

1.75

Current Price

(24.64)

(24.64)

(24.64)

(24.64)

P/L $

(24.64)

(0.57)

1.99

3.44

P/L %

(100%)

(2%)

8%

14%



    

Catalyst

Deal closes and investors take notice that the WB pref is the same at WFC pref.
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