What a Crazy Week

Lehman Brothers (LEH) went bankrupt, Bank of America (BAC) made an offer for Merrill Lynch (MER), and American International Group (AIG) was given an $85 billion loan in exchange for being nationalized. All this came on the heels of the nationalization of quasi-government entities Freddie Mac (FRE) and Fannie Mae (FNM).

The Merrill Lynch buyout looked terrible for Bank of America, and its stock was pummeled. When announced, the deal valued Merrill at $29 a share. Since it was an all stock deal, and BAC's stock was falling, MER traded between the high teens and low twenties. The deal falling through was seen as a "calamity" for Merrill.

Then it was announced that the government had a bailout plan. Some sort of dump would be created for all the banks to shovel their garbage into. The SEC prohibited short selling of financial stocks. For about a day and a half, the markets soared. Rupert Murdoch called it "a government-imposed short squeeze."

Merrill Lynch closed at $29.50 on 9/19/08. Now there's talk that Bank of America got a great bargain, and it might be better for Merrill that the deal doesn't happen. How quickly things change in this crazy market. As another example of the craziness, take a look at how State Street's (STT) stock traded. It opened the week at over $70 per share. Mid Thursday, it was below $30. It closed the week above $60.

As the market was tanking until Thursday's announcement, three month Treasuries were in such high demand that their yield was negative for a brief period. Investors were willing to lose money in treasuries than to stay in stocks.

The crisis that started with subprime was not expected, by many people, to be this grave. Investors greeted financial institutions' billion dollar losses with the view that the worst was now behind us. Ben Stein in August 2007 called the market's worrywarts "Chicken Little's brethren." While acknowledging that it could get worse, Stein thought that the effect of subprime losses "by the metrics of a large economy...is nothing." (I don't get the whole Chicken Little thing, as in the Disney movie of the same title, the sky was falling.)

The subprime crisis turned into a credit crisis, which spiraled out of control. Treasury Secretary Paulson's briefing "on the catastrophic potential" of the crisis "shocked [lawmakers] into uncharacteristic silence." If the government does not bailout the financial system, it is said, there won't be much of a financial system left. So it appears that the sky really is falling.

The proposed bailout, whose price tag Barclays estimates at around $700 billion to $1 trillion, has the government and government sponsored entities buying mortgage backed securities from financial institutions with headquarters in the US. While most agree that a bailout is necessary, there is already some wrangling in congress, with Democrats wanting to attach things like a stimulus and unemployment benefits to any bailout legislation. Depending on the level of bickering and posturing, it may take weeks before there's anything for Bush to sign into law.

There are lots of questions. How will the mortgage backed securities be valued? What happens to all the non-mortgage crap like CDOs and SIVs? What happens to financial institutions not headquartered in the US? What's going to happen to the sovereign debt rating of the US? What of the moral hazard risk (the message seems to be if you're going to be greedy and reckless, make sure you take the world down with you if you want a bailout)? Will anyone be jailed? Will the credit rating industry (Moody's, Fitch, S&P), which bears a lot of responsibility for the current mess, be reformed? Are we now setting up the next boom and bust?

Many banks are still expected to fail, the number depending on how the mortgage backed securities end up being valued. Some economists say a recession is unavoidable (but I thought we were already in one?). Nouriel "Dr. Doom" Roubini, an NYU economics professor who was laughed at in 2006 for his predictions, is now the go to guy. He says the bailout, if it works, will shorten the coming recession to a year and a half. Clement Gignac, Canada's National Bank chief economist, predicts the US will have a severe recession that will last a year.

If these two and others of a similar view are correct, the recent stock market rally may be short lived. Stocks usually begin to rebound about six months before the economy does. If a recession is going to last another year, stocks may still head lower.

Being a mostly long term investor, I'm not selling my General Electric (GE), Johnson & Johnson (JNJ), Philip Morris International (PM), or Procter & Gamble (PG) stock. While it's now tempting to buy financials, particularly their high yielding preferred shares, I'm going to sit out. Those long term investors who invest a portion of their income on a regular basis should probably continue to do so.

Disclosure: At the time of writing, I own GE, JNJ, PM, and PG. Additionally, I own pretty much worthless MER puts (but a lot can go wrong between now and January). I hope the puts stay worthless.


Stocks to Watch

The recent market plunge is almost certainly creating investing opportunities. Since pretty much everything is getting cheaper, it can be difficult sorting out the good stuff from the bad.

Anheuser-Busch (BUD) and UST (UST) are two companies that are probably in the good category. I'm putting them on my watch list.

Anheuser, which holds a 48% share of the US beer market, recently received a $70 per share offer from European brewer InBev. The deal is expected to close in the 4th quarter of 2008. As I'm writing, BUD is trading around $64.30 a share, or 8.86% below the offer price. This does not include the dividend payment (probably $0.37 a share), whose ex-date will be in November. A-B shareholders are expected to approve the deal on September 29. Although 19 banks have committed to finance the deal, investors are nervous about the $49 billion price tag, given the credit crisis.

UST, the leading smokeless tobacco maker, received an offer from Altria (MO) for $69.50 a share. The deal is also expected to close in the fourth quarter of 2008. As I'm writing, UST is trading around $66.84, or about 3.98% below the offer price. This does not include the dividend payment (probably $0.63 a share), whose ex-date will be in December. Investors seem to think that this deal is likelier to happen. The price tag is around $11.6 billion.

While both companies are overvalued at the current prices should the deals fall apart, they are decent stocks to own for the long term and will eventually trade higher than today's prices. Both pay good dividends and sell products that tend to do well during tough times.

Disclosure: I hold no positions in any securities mentioned. I am considering buying both stocks, but will wait to see if the market panic will drive their share prices lower. Disclaimer.


Bought ESLR Puts and GE Update

While everything is falling anyway, the Lehman bankruptcy is driving shares of Evergreen Solar (ESLR) sharply lower. This is because Lehman underwrote the recent convertible share offering and ESLR agreed to lend Lehman about 31 million shares.

I've been slow on this and should have bought puts yesterday. As it is, I bought two Oct '08 2.5 puts for every hundred shares of ESLR. Should the stock go to $0 between now and mid October, I'll make money. My cost basis for ESLR is now $5.89 a share. I sold Jan '10 7.5 covered calls for $1.6 on 9/11/08. (I list all my transactions on the sidebar at the bottom, if you're interested.) Should ESLR go to $0, those calls will be worthless and my cost basis will become $4.29. The puts will be worth around $2.50. I'll make $0.51 a share if that happens.

General Electric (GE), another of my holdings that's been in free fall (although it's in positive territory as I'm writing), is going down for a few reasons. GE has no exposure to US mortgages. However, GE has exposure mortgage assets outside the US. These are insured by AIG, which is in danger of going belly up. Next, GE is involved in the credit card business. Investors think more consumer defaults are coming. Investors are concerned that GE will lose its AAA credit rating. Additionally, the bankrupt Lehman Brothers owned some $500 million worth of GE shares. That's not that much compared to GE's market cap, but it's pretty big in absolute terms.

I think GE will do fine over the long term. In the meantime, I hope that the price will stay depressed for a while so my dividends are reinvested at current or lower prices.


Why Is MER Trading Significantly Below the $29 Per Share BAC Offer?

A reader sent me an email, asking me to explain to him why Merrill Lynch (MER) is trading around $19 per share when Bank of America (BAC) offered to buy MER for $29 a share. Is it the short sellers?

Well, maybe, if they're driving down BAC's share price.

The media is floating around the story that BAC offered $29 a share for MER, but this is based on BAC's closing price of $33.74 on Friday. What BAC offered was a share swap. If the deal goes through, MER shareholders will receive 0.8595 BAC shares for each of their MER shares. So, for example, if you own 100 Merrill shares, if the deal goes through you'll get 85.95 Bank of America shares.

This means that MER's share price is now tied to BAC's. It's trading at a sizable discount to its implied deal value (with BAC trading at $27 and change as I'm writing, the implied value of MER is $23 and change a share), but that's because traders aren't certain the deal will go through and there's a possibility that BAC shares will continue falling.

If you think the deal will fall apart and you own MER, consider selling your shares and buying BAC instead. Part of the reason BAC is falling is that shareholders don't like the deal. If the deal falls apart, BAC may rise. If you think the deal will go through and that BAC has bottomed, continue holding your MER shares. In either case you'll be getting BAC shares. The price is still up in the air.

Another way to get into BAC, which I wrote about previously, is to buy its L Series convertible preferred. They currently sport a dividend yield of around 9%.

I personally would stay away from financial stocks right now. Instead, I'll gamble with small sums on puts and calls.

Disclosure: I own Merrill puts. Disclaimer.


Options Are Better Than Stock Positions When You're Gambling

I wrote about the advantages of buying puts over short selling a stock previously. Many investors (gamblers in this context) are worried about what's going to happen with Lehman Brothers (LEH). Those who bought the stock on Thursday and Friday are hoping some sort of deal in the next few hours will send the stock flying on Monday morning. Those who sold the stock short in the last couple of days are hoping for the opposite. Many in both groups probably haven't been sleeping well this weekend.

I bought a few Lehman September 2.5 puts on Friday (along with Merrill January puts). While I'm certainly excited about all the news and speculation surrounding Lehman, it will be no great loss to me if the stock goes up tomorrow. Those who have shorted the stock, on the other hand, may be in for some pain. Should no deal favorable to shareholders get inked, those who have purchased the stock will get hurt, although unlike the shorts they can only lose how much they decided to gamble.

Both groups, however, would probably be better off buying options instead. They could have risked less money to obtain the same desired profit. Consider the shorts. The September 2.5 put could have been bought around $0.40 per contract. (I bought mine for $0.51). That's $40 (plus broker commissions). Say the shorts are correct, and Lehman goes down near $0 a share. That put will be worth near $2.50 a contract. Let's say Lehman drops and the 2.5 put trades around $2.20. For every $40 put at risk, they'd get a gain of $180.

The stock was under $4 a share when the put discussed above traded around $0.40, but let's say LEH traded at $4. Shorting 100 shares would place $400 in the short seller's account. If Lehman goes to $0, the short seller will get to keep the entire $400. The put buyer would have to buy three puts (for a total of $120) to get a better potential gain ($540). The put buyer's risk, in this example, would thus be limited to $120 (plus commissions). The short seller's risk is unlimited. Suppose the news for Lehman is good and the stock goes up to $10 a share. The put buyer in this situation will lose $120. The short seller will lose $600. The moral here: less risk and bigger potential gain of buying puts over short selling.

Now let's look at the long side. Suppose you bought 100 shares of Lehman at $4 a share. That's $400 at risk. Let's say you're right, and the stock goes to $10 on Monday morning. You'll have made a profit of $600. Let's say instead you bought the September 4 call, at the day's high price of $1.42 a contract. Again, let's say you're right about the stock's direction, and Lehman goes up to $10 a share. That call will be worth a little over $6. Let's say it's worth $6. You'll have made a profit of $458. Let's say you bought two contracts. You'd have put $284 at risk. Your return, however, would be $916.

Let's say you're wrong about the stock's move. No one wants to help Lehman, and its stock falls to near zero. Had you bought 100 shares at $4, you would lose $400. Had you bought two calls instead, you'd have lost $284.

When you're gambling with stocks, options offer greater potential rewards and less risks. And this is gambling, after all. No one knows what will happen, not even those involved in the weekend deal making.