Financials drop; SanDisk lower on hedged basis amid deal chatter; Nortel quiet after cutting view

By Rebecca Melvin

New York, Sept. 17 - The convertible bond market was bid lower Wednesday as a crisis in confidence mounted after American International Group Inc. was taken over by the U.S. government to avert a company collapse and a money-market fund holding bankrupt Lehman Brothers paper exposed investors to losses.

Credit spreads of banks and investment-services firms widened significantly and "people were more skittish," a New York-based sellside analyst said.

"As they watched markets trending weaker in the middle of doing something, they were quick to put on the breaks," the analyst said.

On Tuesday, the fear was that if AIG failed, there would be tremendous losses that would cause liquidity to dry up everywhere as people needed to sell to cover their positions. On Wednesday, even though that failure was averted, the fear remained as investors switched their focus to the next potential failure.

Toward the end of the session, the market recovered slightly and got quiet, an East Coast-based sellsider said.

"People are holding their breath," he said, referring to news that money-market fund Reserve Primary Fund "broke the buck" and spurred a scramble to get out of funds.

Outside of financials, SanDisk Corp. convertibles were higher outright, but lower on a hedged basis, amid speculation that the flash memory drive maker's rejection of Samsung's bid would bring a better deal. SanDisk shares rose 39%.

Nortel Networks Corp. bonds were mostly quiet but indicated much lower after the telecom-equipment maker reduced its revenue forecast, citing lower sales, and said it is putting its Metro Ethernet Networks business up for sale.

AIG, financials lower

AIG's 8.5% mandatory convertibles were lower despite the government takeover that includes $85 billion in loan guarantees at Libor plus 850 basis points, which will enable the company to conduct an orderly sale of assets.

The mandatories were 6 versus a share price of $2.05 at the close Wednesday, compared to 9 versus a share price of $3.75 at the close Tuesday.

Shares of the New York-based insurance giant (NYSE: AIG) fell for a fourth consecutive day, ending down $1.70, or 45%.

Financial credit default swaps were wider across the board as the equities of Morgan Stanley & Co. and Goldman Sachs & Co. were slammed.

News that money-market fund Reserve Primary Fund broke its dollar price due to Lehman paper helped promote an early panic, but by the end of the session more rational heads prevailed, one sellside source said. Broker names were hard hit, but banks held in a little better.

Goldman Sachs' credit spread widened 130 bps to 600 bps to 630 bps, while Morgan Stanley moved to points up front.

Bank of America Corp. and Wells Fargo were wider by about 20 bps each, and Citigroup was wider by 35 bps to 340 bps to 350 bps. But Wachovia Corp. widened a much larger 120 bps to 710 bps to 760 bps.

"People don't know what's going on, and they are seeing things gapping lower and waiting for the next shoe to drop," a New York-based sellside analyst said.

"They are looking for someone else to pick on: Wachovia, Morgan Stanley, Goldman Sachs. Washington Mutual is also taking a hit," he said.

Even though both Goldman and Morgan Stanley posted fairly decent results, there seems to be self-fulfilling prophecy that's a function of where the markets are, he said.

The Securities and Exchange Commission stiffened regulations against manipulative short-selling after the routs in AIG and Lehman. The new rules force traders to borrow shares before selling them short and make it a fraud for investors to lie to their broker about locating stock to close positions.

Short interest outstanding in retail is very high, a New York-based buyside financials analyst said. "I never engaged in naked short selling. I always thought it's illegal so I don't know who is doing it."

"Looking at the way Goldman and Morgan Stanley are trading, it's not good. I think probably that's the story in a nutshell. With the Fed not willing to step in, they are vulnerable."

"They're running for the exits out of my group, going into health care, etc., which is understandable," the buyside analyst said.

"When the dust clears, I think Morgan Stanley and Goldman Sachs will be around," the analyst said. "The market has a way of testing the worst-case scenario."

"The next thing people would watch for in my area is any potential runs on the bank - that would be the next negative. Any pressure on the FDIC in terms of a large bank failure, and using up federal deposit funds would be a big negative," the analyst said.

People are also watching Libor; they'd like that to come down a little, and other nuanced indicators of liquidity," the analyst said.

"It is really ugly," the buysider said. "There's the fear of unforeseen collapse, and people are husbanding their capital, raising cash and being as defensive as they can."

SanDisk rise outright, lower dollar neutral

SanDisk 1% convertible senior notes due 2013 traded at 82 early in the session, according to one analyst. It was last seen at 80.5 versus a share price of $20.92, compared to 68.75 versus a share price of $15.04 on Tuesday.

"It was ugly," a sellside trader said, referring to the surge in shares with which the bonds didn't keep up.

The other SanDisk 1% convertibles due 2035, which were formerly owned by M Systems Flash Disk Pioneers Ltd., were seen at 90.

Another source said he put them at 95 and hadn't seen them cross Trace.

Shares of SanDisk (Nasdaq: SNDK) surged $5.88, or 39%, after the Milpitas, Calif.-based chip maker rebuffed a $5.85 billion bid by Samsung. The move could encourage another rival in the space such as Toshiba to step in.

"Speculation is that a deal will get done," a sellside analyst said.

SanDisk acquired M-Systems Flash Disk Pioneers in a $1.55 billion swap-share deal in the middle of 2006.

Nortel falls after guiding lower

Nortel Networks' 1.75% convertibles due 2012 (the A tranche) were seen closing at 58 versus a share price of $2.68 Wednesday, compared to 72.5 versus a share price of $5.30 on Tuesday.

Nortel Networks' 2.125% convertibles due 2014 (the B tranche), which also trade frequently, were seen closing at 52, compared to 63 on Tuesday.

Shares of the Brampton, Ont.-based telecom networking equipment maker (NYSE: NT) closed down $2.92, or 49%.

The devastation to equities - a sellsider familiar with the name said he didn't see the bonds trade - occurred after Nortel said it was reviewing strategic options, lowered guidance for the quarter and full year, and talked about selling assets.

The company is feeling significant pressure from its carrier customers cutting spending.

"It is clear that the business environment in which we operate requires additional immediate and decisive actions," chief executive Mike Zafirovski, who has been trying to turn around Nortel for three years, said in a statement.

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