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Knight Defies 'Too Big to Fail' Trade: Street Whispers

NEW YORK ( TheStreet) -- Traders that speculated on the rescue of Knight Capital Group (KCG - Get Report) were rudely disappointed by a Monday lifeline that overcame a $440 million technology-inspired trading loss.

That's because the $400 million capital raise will greatly dilute existing shareholders and keep Knight's stock muted, as opposed to a government lifeline or negotiated bailout that would have sent shares soaring.

That reversal of fortune signals that traders may not be able to rely on Uncle Sam for a quick profit from the next financial blow up.

Just over four years ago, the collapse of Bear Stearns gave financial sector investors their first taste of 'too big to fail' bailout profits. When the Federal Reserve brokered the lender's $2 a share takeout by JPMorgan Chase (JPM - Get Report), many financial sector investors swooped in expecting a higher offer to be consummated -- and were rewarded with Bear's eventual $10 a share takeout.

While Knight's deal -- a preferred stock sale that will dilute existing shareholders by over 70% -- is punitive to investors, it nevertheless restores the firm's capital position once and for all. Now the market maker can focus on rebuilding its equity trading operations, which accounted for roughly 10% of U.S. stock trading prior to the August 1 software meltdown.

Knight Capital is issuing preferred stock that can be converted into 267 million common shares at a strike price of $1.50, diluting existing shareholders by over 73%. Counterparts like Jefferies (JEF), Stifel Financial (SF), GETCO and TD Ameritrade (AMTD), in addition to financial heavyweights Blackstone (BX) and GETCO are among the investors in Knight's capital raise.

While it's debatable whether Knight Capital's chief executive Tom Joyce can be celebrated for the company's survival, his decision to expediently raise capital at any cost may be taken as a cue for other financial institutions up against the Wall Street eight ball. In the past, Wall Street CEO's have played a dangerous game of trying to get a good rescue price over raising capital, with disastrous consequence.

No doubt, Joyce will likely still face a flurry of shareholder lawsuits for the $440 debacle and there's no guarantee that confidence will be restored in Knight's market making business.

But for now, the company's current share price over $3 appears to be a vote of confidence by the market, albeit a money losing one for shareholders and speculators.

Knight's dilutive rescue should be taken as a wakeup call to financial sector investors, who now have a painful example of how new equity is the first line of defense for a firm in crisis.

-- Written by Antoine Gara in New York

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