Four Wall Street Titans Flunk Investing 101

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By Allan Sloan
Tuesday, January 22, 2008

The one thing Wall Street knows how to do is raise money. The proof: Even with financial markets threatening to melt down worldwide, four of the Street's biggest firms have attracted a total of $50 billion of investor cash to help cover losses on subprime- mortgage-related carnage past and on carnage yet to come.

That's the good news, but there's bad news wrapped around it.

When you take out your calculator, you see that these firms -- Citigroup, Merrill Lynch, Morgan Stanley and UBS -- have frittered away billions of dollars by selling their stock for much less than they paid for it.

Hello? Didn't we learn in Investing 101 that the idea is to buy low and sell high? Yet the Wall Street Four, filled with financial geniuses who scarf up seven- and eight-digit pay packages, have done the opposite. The firms bought stock dear when they felt flush and are now selling it cheap because they need the money.

One Merrill deal is the simplest example. In December, the Thundering Herd sold $5.6 billion of common stock at $48 a share to raise capital. Earlier in the year, however, it paid 75 percent more -- $84.88 -- for the shares it bought in the market as part of a buyback program. Its sale of $6.6 billion of convertible preferred stock in January fetched an implied price in the low $50s, still way below $84.88. (For more details on these deals, see http://www.fortune.com/sloan.)

Companies typically say that buyback programs "enhance shareholder value" and offset the share dilution caused by employees exercising stock options. Skeptics like me also assume that supporting the share price with substantial buying is a significant part of the motivation.

This is supposed to be a win-win strategy, but sometimes it's lose-lose. The biggest losers in the Wall Street Four follies are shareholders of Citigroup, which has raised a total of $20 billion in two deals and is looking to raise more. Both deals involve securities convertible into common stock at varying prices. Rather than get caught up in complex math to value this stuff, let's just assume that sophisticated buyers such as the sovereign wealth funds of Abu Dhabi and Singapore know what they're doing. They bought these converts rather than Citi common because they considered them a better economic deal. So even though the conversion prices are as high as $37.24 per share, it's reasonable to assume that the value these deals place on Citi's common is about what it fetched when the deals were being negotiated -- the high $20s and low $30s.

What do you think Citi paid last year when it repurchased its own shares? Would you believe an average of $53.24?

Now let's look at it another way. Citi has recently raised $20 billion, as we've seen. From 2005 to 2007, Citi spent a bit more than $20 billion buying back its shares in the open market, acquiring 434 million of them. The $20 billion of securities that Citi has just sold will convert into 575 million to 600 million shares, by my estimate. Those added shares will dilute the stake of Citi's other shareholders.

In addition, Citi will have to pay fat rates until the securities convert: 11 percent (before taxes) on Abu Dhabi's $7.5 billion December deal and 7 percent (after taxes) on January's $12.5 billion of convertible preferred. That's some serious vigorish.

I'll spare you the arithmetic on Morgan Stanley (which has raised $5.6 billion) and UBS ($11.9 billion). But you get the point.

Why am I writing this, other than to rag on these firms? Two reasons.

First, that capital is precious when you need it -- and you're never sure when you're going to need it, so you'd best keep plenty around.

Second, that stock buybacks aren't necessarily good for shareholders, current conventional Street wisdom notwithstanding. The theory, promoted by "activist" shareholders and practiced by my employer, Time Warner, among others, is that buying back lots of stock enhances shareholder value. But as these cases show, buybacks can also erode shareholder value.

Look, I think it's great that the Street has raised all this money.

I just hope that when things get better, Wall Street remembers its past buyback follies. Maybe next time the Street will sell shares when they're being bid up rather than find itself forced to sell at times like these. Repeat after me: Buy low, sell high. Not the other way around.

Allan Sloan is Fortune magazine's senior editor at large. His e-mail address isasloan@ fortunemail.com.


© 2008 The Washington Post Company

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