Thursday, July 3, 2008

Eric Sprott on the Markets


Eric Sprott
Sasha Solunac

Sprott Asset Management

Ratchet (financial definition): An anti-dilutive provision where an investor is granted
additional shares of stock without charge if the company later sells the shares at a
lower price.

Screw (Sprott definition): A highly dilutive provision where an existing investor is
granted, without his approval or knowledge, an increasingly smaller share of the
company at an increasingly lower exit price (usually the result of a ratchet bestowed
on other investors).

Is it a ratchet or a screw? We’ll let our readers be the judge. But whatever you call it, and
punning aside, the evidence grows daily of a disturbing trend in place that is leaving existing
shareholders nailed. As the troubled financial sector continues to post massive loss after
massive loss, and inundate the markets with equity offering after equity offering after equity
offering, it would appear that transparency has taken a back seat to the banking industry’s
desperate need to raise capital from whomever would buy it and at whatever terms would
cinch the deal – even if it involves selling their souls to the devil. Unbeknownst to the
shareholders of these financial institutions, they are having the wool pulled over their eyes
by being subjected to the possibility of bottomless dilution with less than forthright
disclosure. As we’ve long written, we believe the banking system is effectively bankrupt.
They are dead men walking. The fact that they are unable to raise capital the oldfashioned
way (selling common shares at market prices) is proof positive of our thesis.

Instead, they have to compel investors to buy their sorry shares through either way-belowmarket rights issues (an abhorrent abuse of capitalism that invariably results in a freefall) or by baiting new investors with no-brainer can’t-lose ratchet provisions. Either way, existing shareholders are taking it on the chin. But the banks don’t care. Neither do the regulatorsnor the Treasury nor the Fed. Capital must be raised come what may! It’s gotten so bad that the very viability of the financial system seems to hinge on whether or not the next equity offering can be pulled off without a hitch. It’s a misallocation of capital of tremendous proportions, for the sector that is currently in the greatest need of capital is also the sector least worthy to receive it.

The horrendous performance of financial stocks of late speaks for itself – perhaps the
markets aren’t so easily fooled. But those investors tempted to bargain hunt best beware.
Due to lack of transparency running amok, investing in the financial sector is chalk full of
minefields. One example that immediately comes to mind is an article in the Wall Street
Journal last week titled “Banks Find New Ways to Ease Pain of Bad Loans” . Have the
banks done something value-added here? Have they actually found ways to mitigate their
losses by improving their recoveries of bad loans? 1 Not at all. The article is about how
some banks, even big ones like Wells Fargo, are using accounting gimmicks to make it
seem like things are getting better. For example, “improving” the write-off rate of
nonperforming home equity loans by changing the past-due time period (after which they are
deemed to be in default) from 120 days to 180 days. Or offloading troubled loans onto
subsidiaries, thereby erasing them from their own books and improving their regulatory
capital level, even though the bank is still fully accountable and liable for the losses that are eventually incurred from these bad loans. It’s a wonderful magic trick – now you see them…
now you don’t! Would that all bad loans can be made to disappear so easily. Unfortunately
for the banking industry, accounting trickery does not reality make.

They are merely gaming the system to make things look better than they really are, in the hopes that unwary investors will be lulled into believing that things are improving when they are not. Another recent example that got our goat is courtesy of Lehman Brothers. On the day of closing their $6 billion equity offering, they announce a management shake-up whereby the CFO and the President and COO are replaced.

We would question why such a material decision, which seems unlikely to have happened overnight, wasn’t mentioned before the offering. Could it be that the spirit of full disclosure, lest it hinder the equity offering, must fall by the wayside? But the most egregious example of lack of transparency (a.k.a. turning the screws on existing shareholders) is the “full ratchet” provision that has recently come to our attention and, doubtless, is currently making the rounds of many of the recent equity offerings in order to sweeten the deal for reticent investors who have sizeable cash to invest.

It would appear that in order for the equity raise to succeed, lead investors are being given preferential treatment at the expense of existing shareholders who are being subjected to the potential for limitless dilution should financial stocks continue to go down in value. Such provisions are appalling, but what is even more appalling is that the existence of these not inconsequential provisions is only coming out of the woodwork in the footnotes of subsequent 10-Q’s. It’s an abomination of supposedly free and transparent Western financial markets.

We always wondered who in their right mind would invest in a financial institution that is
scrambling for capital just when the news is clearly going from bad to worse. As we already
mentioned, we believe the banking system is bankrupt. Thanks to overleverage, if all their
assets were to be marked down to what the market would be willing to pay for them, we
believe they would have no capital. Save for government Treasuries, there isn’t an asset
class on bank balance sheets that hasn’t fallen precipitously in value. What capital the
2 “Lehman Brothers Removes Finance, Operating Chiefs”, Associated Press, June 12, 2008.

Banking system does have is from recent raises, but this will likely disappear when future
massive writedowns are announced. Who would be fool enough to invest in banking shares?

The list is growing shorter. But there were at least some smart investors who noted the
downward trend and successfully negotiated for downside protection. We know of at least
two cases (though there are doubtless others); namely, Merrill Lynch’s $12.8 billion investment from Temasek (the Singapore sovereign wealth fund) and Washington Mutual’s $7 billion raise from TPG (a private equity firm). Quite unbeknownst to the general public at the time, downside protection was built into these equity raises to protect these investors. They are called “look back” provisions or “full ratchet” compensation. We believe it is more accurate to call them “death spiral” securities. They work as follows. The investors in the equity raise would have their investment “protected” by a provision which states that should the bank afterwards raise money at a lower price than what they paid, these investors would be compensated retroactively by having their initial investment priced at this lower price, thereby being issued new shares for free.

It doesn’t take a mathematician to see how these provisions can result in massive dilution should the bank subsequently raise even a paltry amount of capital. A new offering will trigger a lower price because of the dilution it would cause, which would trigger even more dilution because of the lower price, which would then trigger an even lower price because of the even higher dilution, etc. This is why we call such securities a death spiral. They hurt the price of any and all future equity offerings and open the door for potentially limitless dilution of existing shareholders if and when the bank goes to the markets for more capital at ever-lower prices.

However, unless the bank goes bankrupt, these investors can’t lose. And we already know
to what lengths the Fed will go to prevent a banking bankruptcy. It’s heads I win, tails I win.
They can even short the stock in the expectation that it will go down and still not lose.

At the next financing, which is sure to come, they will be made whole... even making money on the short! It’s a perverse situation. Even if they don’t short (or aren’t allowed to short) they still
can’t lose. It’s like being given a free put option written by existing shareholders. They get
all the upside and existing shareholders (insult to injury) pay them on the downside! It’s the
worst way to raise equity. We wouldn’t even call it equity. It comes at a tremendous cost to
the already beaten up shareholders of these financial institutions. How did this happen?
Because these are “private” transactions, and thus no prospectus was required at the time of
the offering. The banks disclosed only what they wanted to disclose. It is only after the fact,
in the footnotes of subsequent 10-Q’s, that shareholders (if they dig deep enough) will
realize that they got nailed/ratcheted/screwed. How many other financings were done on
this basis? Only time will tell.

In the meantime, it is little wonder that banking indices are in freefall and the demand for
new bank equity is becoming increasingly muted. Investors are finally beginning to say: no
mas! When regulators have to get involved in order to push financings through (for instance,
Bradford and Bingley in the UK), it is a signal for ordinary investors to steer clear of the
financial sector. It’s a misallocation of capital… good money chasing bad… that can
ultimately only be resolved by a massive central bank bailout. You don’t want to be a
shareholder when this happens… and in the interim be subjected to an unacceptable lack of
transparency. Financial shares, if they weren’t already, are now toxic. They will become
only more so with each equity offering.

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