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Beginning of the End of the Subprime Mess

UBS Quantifies Subprime Losses

UBS, the Swiss bank, just quantified the losses from subprime to an additional US$ 10 billion (in addition to the $3.4 billion taken a few months ago). This is a huge loss no doubt but I think this is a sign of the the beginning of the end of the subprime mess.

In addition to taking the loss, the company announced that it will raise capital by:

  1. Selling a 9% stake (11 Billion Francs) via mandatory convertible notes to Singapore government's investment arm
  2. Selling roughly a 1.6% stake (2 billion Francs) via mandatory convertible notes to a Middle Eastern entity (speculated to be the government of Oman's investment arm)
  3. Plan to convert the cash dividend to a stock dividend (yikes!)
  4. Re-sell 26.4 million shares held in treasury that were to be cancelled

Sizeable dilution for shareholders but shoring up capital is a primary need for the financial companies. The stock is actually up around 2% today (on NYSE in US$ terms) after all that massive dilution (although note that this is a megacap and has a market cap of around $100 billion so the capital injection probably only shaves off 15% of market cap).

You can tell that the market has priced in a lot of the negative news already (that's why the stock actually went up). This tells me that we are basically near the end of the write-offs. If the US economy slows down, profits may decline due to other reasons (like lower trading income; asset management; M&A; etc) but the subprime uncertainty seems to be priced out right now in my opinion.

Risk Has Indeed Been Shared

Some critics don't think secrutization of risky assets, like subprime mortgages, was beneficial to society but I have always felt that it helped the capital markets and economies in general. We see the benefit of risk being spread across the world when European investors and banks take losses from US assets. It is clear from the subprime situation that the risk has indeed been spread to multiple parties--and this is a good thing! Instead of one US bank completely collapsing, we have multiple investors and banks getting hit for a little bit.

Bond Insurers May be Near a Bottom

My thinking on bond insurers parallels that of the investment banks with subprime losses. I suspect most of the subprime losses are priced into the bond insurers. However, there are a few unique issues with the bond insurers.

First of all, the market cap is so low that any means of raising capital can seriously hurt the shareholders. When Citi or UBS raises $10 bilion, it's only around 10% of market cap; whereas Ambac raising $1 billion would be 30% of market cap (although the way the stock is surging today on news of MBIA capital injection, things won't be so bad).

In addition, I think one or more bond insurers may not make it. Any big problems likely means that someone will buy out the insurer but equity holders will lose big. Just because a company survive means nothing if your shares are bought out at a low price. In contrast, I find it hard to believe that one of the big investment banks, brokerages, or commerical banks, will go bankrupt.

The two above risks are what makes bond insurers interesting--and attractive. If someone wanted a contrarian bet on financials, something like BAC, C, MER, or BSC, is the easy choice; but ABK, MBI, and others, likely provide higher upside potential (with potentially big downside as well).

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