Knight Needs More Than Loan Armor (Update 2)

Updated with comments from Fitch Ratings, CRT Capital Group analyst Keven Starke, and market close informatoin.

NEW YORK ( TheStreet) -- Knight Capital Group ( KCG) bounced back in a big way on Friday, following a report that the firm had obtained a credit line allowing it to operate for another day.

The shares shot up 57% to close at $4.05, amid a very strong market rally on surprisingly strong job growth numbers, after the Wall Street Journal reported that Knight Capital had told its clients that the company had obtained a new credit line, allowing it to continue processing trades for its customers for another day.

Shares of the Jersey City, N.J., market maker and facilitator of electronic transactions for wholesale trading clients announced dropped 63% on Thursday, after Knight Capital announced a pretax loss of $440 million, after glitches in its trading software on Wednesday "sent into the market a ton of orders, all erroneous, so we ended up with a large error position which we had to sort through the balance of the day," according to Knight Capital CEO Thomas Joyce, who was interviewed on Bloomberg TV.

Knight Capital announced early Thursday that it was "actively pursuing its strategic and financing alternatives to strengthen its capital base."

KBW analyst Niamh Alexander had said on Thursday that "the Board needs to sell this company ASAP in our opinion if it can't get private financing to shore up capital," because "continuing independently will be challenging without more capital."

Potential acquirers for Knight Capital, according to Alexander, include Goldman Sachs ( GS), Credit Suisse ( CS), and Cantor Fitzgerald, all of which "recently expressed interest to expand into wholesaling organically." The analyst said that KBW would potentially consider JPMorgan Chase ( JPM), Interactive Brokers Group ( IBKR), or Jefferies ( JEF), to be buyers "as they would likely be interested in the trading technology and the retail wholesale network while also potentially eliminating a competitor in the trade execution institutional business."

While investors were clearly breathing a sigh of relief -- pushing Knight Capital's shares well above the takeout value of $3.40 estimated by Stifel Nicolaus analyst Matthew Heinz on Thursday -- other Wall Street firms were shying away, with the Journal reporting that TD Ameritrade ( AMTD) and E*Trade ( ETFCO) we not routing trade orders through Knight Capital.

Knight Capital in June renewed a $200 million credit line with a group of banks led by U.S. Bancorp ( USB) subsidiary U.S. Bank, NA, that included bank subsidiaries of Bank of America ( BAC), Bank of Montreal ( BMO), and JPMorgan Chase ( JPM).

Included among the covenants of the credit agreement was a requirement that Knight maintain certain levels of capital for its broker-dealer subsidiaries, which the company might be unable to meet, following the three-day settlement of its erroneous trades, without securing additional capital from outside.

Alexander says "it's possible that they could be in breach," of the $200 million credit facility's covenants, "but they may not have actually drawn down those facilities."

Alexander calls the new credit line reported by the Journal "very encouraging," but says the company still needs "to do something and do it very quickly. It will be difficult for customers to continue to route trades through Knight unless they are more comfortable about the capital situation."

"It is going to be day by day... something needs to happen for people to feel better about the capital," she says.

Fitch Ratings on Friday said that "exposure to KCG, among large rated counterparties, is moderate and manageable," and that although "numerous institutions that relied on KCG for part of their trading requirements have already directed business to other market makers... it does not appear that any prime brokers had disproportionately high exposure" to the firm.

Fitch said that "even in a bankruptcy scenario, we do not expect any major rated institutions to suffer large losses linked to KCG's difficulties," although Knight Capital's software problems this week "may ultimately lead to a structural change in the equity market-making business."

CRT Capital Group analyst Kevin Starke said on Friday that Knight Capital's trading loss is likely to be recognized on Monday, and that "solving the liquidity problem and capital shortfall that this will cause thus needs to be completed by Monday." Starke also said that "FINRA is on site and stated publicly Thursday that the Company was in compliance with capital requirements, but we wonder aloud whether that is simply because the bad trades have yet to settle."

Starke also said "it is possible though not likely that the capital shortfall can be remedied with internal resources. To solve the liquidity problem, Knight Execution & Clearing Services can draw on the $200 million line, though we are not entirely sure it can borrow the entire amount." The analyst added that "it will be recalled that MF Global too drew down on its lines in the days just prior to being put into administration."


-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.