Citic's close call with Bear Stearns

JPMorganÆs takeover of Bear Stearns lets Citic off the hook but other bail-out investors may not be so lucky with their commitments to subprime-affected banks.
Citic Securities confirmed yesterday that it would not proceed with its investment in Bear Stearns, allowing it to scrap a deal to buy shares at $120 apiece in a bank which currently trades at $6. But a host of other investors who have bought into Citi, Merrill Lynch, Morgan Stanley and UBS are stuck with paper bought at significantly higher prices than current traded levels.

Citic Securities, which is part of Chinese state-owned conglomerate Citic Group, started talking to US investment bank Bear Stearns in the third quarter of 2007 after two Bear Stearns hedge funds were reeling from subprime losses and the investment bank had posted a large drop in profits. On October 22 the two firms announced they had inked an agreement for a strategic partnership.

Citic was to buy $1 billion worth of 40-year preferred securities convertible into about 6% of Bear Stearns equity. The conversion price of Citic's investment into Bear Stearns was around $120, based on the last five days traded prices at the time. Bear Stearns had traded down from a January 2007 high of $171 leading some market commentators to observe that Citic had got itself a bargain. The arrangement was somewhat reciprocal as Bear Stearns would eventually invest $1 billion in Citic's equity, based on Citic's traded share price.

Bear Stearns' share price lost ground all of last week as investors û correctly û feared the worst and closed at $30 on Friday. Then JPMorgan bailed out the beleaguered investment bank over the weekend at a price of $236 million, which translates to a valuation of around $2 per share. Bear Stearns' shares lost 84% on the news, finishing at $4.81 on Monday but gained some ground on Tuesday to trade up to $7 before closing around $6.

Citic said yesterday it will not be going ahead with the investment, which was still awaiting approvals. But while this ended up being just a close call for Citic, other investors who bailed out subprime-affected banks have not fared as well.

Just a few weeks after the Citic-Bear Stearns tie-up, Citi said the Abu Dhabi Investment Authority would invest $7.5 billion to buy up to 4.9% of the bank. Citi issued equity units to ADIA that are convertible into common shares at a price between $31.83 and $37.24 per share. Until conversion in tranches in 2010 and 2011, the securities carry a coupon of 11%, payable quarterly. Citi's shares closed at $30.70 the day the markets learned of the ADIA investment.

Then UBS announced that the Government of Singapore Investment Corporation (GIC) and an undisclosed strategic investor in the Middle East would jointly invest SFr13 billion ($13.2 billion) to take a 10.5% stake in the Swiss bank. The investors bought notes convertible in two years, bearing a coupon of 9%. The shares traded at SFr57.2 on December 7. The conversion price is an average of the December 7 price and the volume-weighted average price of the three trading days prior to the extraordinary general meeting at which the issuer would seek approval, subject to a floor of SFr51.48 and a ceiling of SFr62.92.

UBS currently trades at SFr26.02.

On December 19 China once again stepped up to the plate with China Investment Corporation agreeing to a $5 billion infusion to acquire a stake of up to 9.9% in Morgan Stanley. The US investment bank issued equity units, bearing a coupon of 9% per annum payable quarterly, convertible into Morgan Stanley shares in August 2010. The conversion price was based on traded prices the week of December 17, with a floor set at a premium of 20% to the reference price. The reference price was $48.07-$57.68 per share.

Morgan Stanley traded yesterday around $41.

Merrill LynchÆs gift to shareholders came on Christmas Eve when it announced Temasek and Davis Selected Advisors would subscribe to $6.2 billion of stock at a price of $48 per share. Merrill Lynch traded at $56 the morning of the announcement, so Temasek and Davis seemed to have got a good deal buying at a 14% discount to the traded price (though the investors bought straight equity so got no fixed coupon).

January brought both Citi and Merrill Lynch back on the road for another round of capital infusion. Citi announced it would issue $12.5 billion of convertible securities to a consortium led by SingaporeÆs GIC. The securities have a coupon of 7% per annum, payable quarterly, and convert at $31.62. Citi traded down to $26.90 the same day.

Merrill issued another $6.6 billion of convertible preferred stock that carry a 9% dividend and are convertible in 33 months based on the then traded price, with a floor of $52.40 and a ceiling of $61.31. Korean Investment Corporation, Kuwait Investment Authority, Mizuho Corporate Bank and others bought the stock. Merrill traded around $54.29 that day.

ADIA benefited from the further capital dilution Citi subsequently announced and the conversion price for the securities it holds is now set at $31.83.

Citi currently trades at around $20, while Merrill Lynch was quoted at $44 yesterday.

Specialists say all these investments have been made by the Asian and Middle Eastern investors with a medium- to long-term perspective and share price movements just three to six months later are not the correct way to view them. Indeed, better than expected first quarter results from Goldman Sachs and Lehman Brothers yesterday coupled with expectations of an interest rate cut in the US caused sentiment on financials to rebound and most bank shares gained, albeit marginally, corroborating how nervousness is driving trading rather than fundamentals.

Further, the investors are in many cases the largest single shareholder in the banks post-investment û a position they would not easily have been able to achieve through open market purchases. Another point specialists make is there is no way of knowing when markets have bottomed, thus buying at bargain basement prices is nigh impossible.

And a bad deal for one side is a good deal for the other. Bear Stearns has been hammered on the stockmarket but JPMorgan is widely perceived as having got a good deal and its share price gained 10% on Monday after the deal was announced to close at $40.31 and continued to gain on Tuesday to trade around $42.50 midday.

After Citic and Bear Stearns announced their cross-shareholding deal, it seemed that every other bail-out investor managed to secure a better deal than the Chinese saviour, with fixed coupons and in some cases discounts to prevailing share prices. But Citic is now no doubt having the last laugh as its $1 billion is still intact.

And even if all the points that specialists make with respect to the investments already committed are correct, the questions that remain to be answered are: which financial institution will be next to go belly up? And when it does, will investors from Asia and the Middle East be prepared to dole out cash again given how their first round of investments are trading?
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