Banks

Return to Article

WaMu Preferred Offering 'Priced to Sell'

Liz Rappaport

Some investors aren't crying over Washington Mutual's(WM Quote - Cramer on WM - Stock Picks) dividend cut for too long.

According to fund managers participating in the deal, investors including equity funds and more typical convertible bond investors are mopping up the $2.5 billion offering of perpetual convertible preferred stock WaMu announced Monday, in conjunction with its decision to slash its dividend. The convertible deal is expected to price Tuesday night, and it will carry a 7.5% to 8% coupon -- making for a relatively attractive opportunity, the investors say.

"The instrument is well-priced, and carries a nice dividend," says Vadim Iosilevich, principal and head of trading at hedge fund Alexandra Investment Management, who has put in an order for an allocation of the deal, which is being led by joint underwriters Morgan Stanley, Lehman Brothers, Credit Suisse and Goldman Sachs. "It is priced to sell."

According to Iosilevich's models, which blend the valuations of Washington Mutual's other debt, its equity, other outstanding convertibles and the cost of buying protection against the company's default in the derivatives market, the price of the new security is between 5% and 10% cheaper than what the model's so-called fair value would warrant.

Convertibles are often the asset class of choice for companies that need capital, but suffer from troubled credit outlooks. Straight debt issued in the corporate bond markets would cost the issuer a much higher coupon payment in many cases. Because a convertible instrument gives the investor the promise of potential equity returns in the future, the coupon payments are naturally lower.

According to investors, the WaMu offering is already trading 4% higher in the so-called gray, or pre-issuance, market. That means investors, assuming the security will price at par, are willing to buy it at 104 cents on the dollar. That compares with other recently issued financial sector convertibles -- Prudential Financial's(PRU Quote - Cramer on PRU - Stock Picks) $3 billion convertible offering of Dec. 7, albeit structured slightly differently, is trading about one point below its initial offering price.

"These financial companies need to refinance their balance sheets, and they're searching for the best asset class in which to do so," says a convertible analyst who declined to be named because his firm is working on the deal. He believes the market may see more like WaMu's deal. In private placements, convertibles have factored in Bank of America's(BAC Quote - Cramer on BAC - Stock Picks) liquidity injection for Countrywide(CFC Quote - Cramer on CFC - Stock Picks) and Chinese Citic Securities' $1 billion investment in Bear Stearns(BSC Quote - Cramer on BSC - Stock Picks), among others.

The perpetual convertible preferred stock is a hybrid security that has elements that resemble a bond, such as its coupon payment. But it also resembles equity, as investors may be forced to convert the security into straight stock under certain conditions. In this case, investors cannot convert the security into common shares until the stock price rises 18% to 23% over its closing price Tuesday night.

Washington Mutual is down almost 8% in Tuesday's trading. Investors may be disappointed that the company followed in the footsteps of lenders like IndyMac Bancorp(IMB Quote - Cramer on IMB - Stock Picks) and Fannie Mae(FNM Quote - Cramer on FNM - Stock Picks) by slashing its dividend. WaMu reduced the dividend to 15 cents per share Monday, from 56 cents per share. It announced job cuts and plans to halt all subprime lending operations as well.

But the stock price is also likely pressured by investors who short stock to hedge against convertible investments, say investors. A convertible, because it has a bond-like element, falls in value when the underlying stock price falls, but not as far, so investors short the stock to capture a relative gain if the convertible slips.