Fallen financials continue to dominate distressed as wild week ends; VeraSun up on strategic alternatives

By Paul Deckelman

New York, Sept. 19 - The week ended Friday in the distressed-debt market pretty much as it had begun, with most of the focus and actual trading activity going on in the recently beleaguered bonds of formerly investment-grade companies like Lehman Brothers Holdings Inc. and Washington Mutual Inc., and of some from companies that were still nominally investment-grade rated, but which have actively traded around in junk bond-land, like Morgan Stanley and American International Group Inc.

Most of those issues were up Friday, clearly better for a second straight session in tandem with an equity rally built on market relief that the federal government will swing into action to take toxic loans off the books of banks and other financial institutions - loans that in one form or another have hung like a heavy anchor around the necks of such companies as the now-bankrupt Lehman and the shaky WaMu and AIG as they struggle to tread water - and which helped to drown Bear Stearns Cos. altogether earlier this year.

Friday's upturn was also seen in the bonds of such non-financial distressed stalwarts as automotive bellwether General Motors Corp. and gaming giant Harrah's Entertainment Inc.

VeraSun Energy Corp.'s bonds were seen solidly higher, in line with a jump in the Brookings, S.D.-based ethanol producer's shares, after it said that it would evaluate its strategic alternatives, which could include the sale of the company. But sector peer Aventine Renewable Energy Holdings, Inc.'s bonds were off after a downgrade by Standard & Poor's.

A wild and crazy time

"It's been a little more interesting, these last few days," a trader said. "Incredible."

He said that he had been talking to a fund manager, and they came to agreement that extreme market volatility can cut both ways - "it's actually just as tough to trade them when they're running up as when they're running down." He said that he actually found it easier to get stuff done on Wednesday and on Thursday morning," before the financial markets' upturn, "than it has been these last couple of hours."

The real key, he said would be "getting through this weekend and then seeing what the follow-through [on Monday] becomes."

He said "a lot of stuff kind of traded up and then drifted back. It's kind of fun to be in the middle of all of this."

Financials dominate the proceedings

He said that fallen investment-grade financials "has been the bulk of the activity," both on Friday and over the course of the whole week.

Despite his desk's specialization in distressed-debt paper - traditionally defined as a bond trading at a spread of at least 1,000 basis points over the comparable Treasury issue and almost always carrying a below-investment-grade rating, we've traded more Morgan Stanley and Goldman Sachs paper than almost anything else today."

Even with all of the good news in the market - that the government plans to set up a mechanism to take bad loans off the balance sheets of banks and other financial institutions, while the Securities and Exchange Commission has called a halt - at least for now - in short selling of financial stocks - he said that the financials "still were as volatile as could be."

For instance, he said, Morgan Stanley's 4% notes due 2010, "a nice short piece of paper, still investment-grade," swung between a high of 88.375 and a low of 82, all in round-lot trading of sizable blocks of bonds, many of them anywhere from $3 million to $10 million.

He said that "it wasn't all in one direction - they were down, they were up, they were down - and that's just an example of all of that paper that's been in a similar zone."

A market source at another desk said the 4s had moved up to 86 bid on brisk turnover of some $22 million by mid-afternoon.

Another source said that on a round-lot only basis the bonds had jumped 13.5 points on the day to 86; counting in all trades, they finished at 84, and gyrated violently over a 20-point range between 70 and 90.

That source saw other Morgan Stanley debt on a wild ride as well, with its most actively-traded issue - the 6 5/8% notes due 2018, with well over $175 million of bonds traded - gyrating between a low around 72 and a high of nearly 90, before finishing at 86, up 18 points on the day, while the company's 4.75% notes due 2014 bounced around dizzily and finally rose 16 points to end at 67. Its 6% notes due 2015 finished up almost that much, and with the same kinds of big price swings, finally getting off the roller-coaster at a price of 84.

Morgan Stanley was reported to still be in merger talks with Wachovia Corp., while at the same time keeping its options open and exploring other possibilities, including selling stakes in the company to overseas financial firms such as HSBC, or getting China's state-run investment company, which currently owns 9% of Morgan Stanley, to buy a bigger piece of the U.S. investment bank.

But the psychological lift given the markets by Treasury secretary Henry Paulson's declaration that Washington will step in to help investment and commercial banks as well as other financial institutions cleanse their balance sheets of toxic mortgage and other bad loans, while the SEC will hold the short-sellers at bay, has eliminated some of the sense of urgency to do a deal like the recently announced and hastily arranged shotgun wedding between Morgan Stanley rival Merrill Lynch & Co. and Bank of America.

Other flailing financials move up

Among the other bonds of troubled financials, a trader saw Washington Mutual's 4% notes coming due in January at 70 bid, which he called a 10-point jump from Thursday's final round-lot transaction at 60. He said that beside the big round-lot trades, there had been "a lot of odd-lot trading as well," amounting to about $7 million of the bonds turning over.

He saw an even bigger jump in WaMu's 5½% notes due 2013, which zoomed to 62 bid from 48 on Thursday, on volume of $5 million.

The Seattle-based top U.S. thrift's New York Stock Exchange-traded shares zoomed $1.26, or 42.14%, to end at $4.25, on volume of 207 million shares, amid reports that it has attracted the interest of potential merger partners such as JP Morgan Chase & Co., Citigroup, Wells Fargo Corp. and overseas players HSBC and Banco Santander.

Lehman higher

The trader said that among all of the issues actually rated as junk - thus excluding Morgan Stanley - the most active name was another fallen financial, Lehman, with its busiest issue its 6 7/8% notes due 2018, which he saw closing at 18.25 bid, up ¾ point on $85 million. Lehman's 4½% notes due 2010 closed at 18.5 bid, up 2 points on the day from 16.5 late Thursday, on volume of $53 million.

Several traders said that "generically speaking," Lehman's senior notes all traded around an 18 level, up from previous levels in the mid-teens.

Meanwhile its subordinated debt, which had been trading at a fraction of a point earlier in the week, was seen having improved greatly on a percentage basis, though only marginally on a price basis, to 1. The busiest was probably Lehman's 6½% subs due 2017 which had traded as low as 1/8 point on Thursday, though it had moved up to 7/8 by day's end, and the bonds bumped up to end at 1 on Friday, on volume of $10 million.

The fall from grace of the 61/2s is perhaps the most dramatic example of the sea change which has swamped the market, obliterating the once-sacrosanct line that traditionally separated the high-grade market from high-yield - let alone separating high-grade from the distressed corner of the junk market. The stunning mass movement of this bond and numerous other issues from Morgan Stanley, WaMu, AIG and the latter's units like American General Finance Corp. and International Loan Finance Corp. has surprised market participants on both sides of the divide, causing them to rethink long-held assumptions about what is and is not junk, and what is and is not distressed.

The Lehman 61/2s' sickening slide to oblivion is a case in point.

Two weeks ago - with the venerable Lehman still considered a fairly solid pillar of Wall Street, owning tens, if not hundreds of billions of dollars worth of various assets - those bonds were trading just a point or two south of 90, according to closing levels on Friday, Sept. 5. Fast forward a week - with the market unsettled in the wake of the unprecedented federal takeover over that Sept. 5 weekend of struggling Fannie Mae and Freddie Mac - and Lehman was now in the gunsights of the short-sellers, and questions were being loudly raised about its viability. Still, its credit ratings from all of the major agencies remained investment grade, and the bonds closed out the session on Friday, Sept. 12 at around the 61 level, with everyone assuming the Federal Reserve and the Treasury would broker a takeover deal for Lehman with Bank of America. By the following Monday, of course, all bets were off - and all hell had broken loose for Lehman shareholders and bondholders, especially the holders of the 61/2s and other sub paper.

One of the traders noted that "certainly, definitionally for distressed, it's now a whole new world, with 1,000 [bp] over as [the demarcation line] for distressed" suddenly being obsolete. "They can hit those kinds of levels sleepwalking," he said.

Indeed, even with the rise in prices on Monday, the Lehman 61/2s' spread over Treasuries at mid-afternoon stood at 45,657 bps over, while the senior 6 7/8% notes due 2018, quoted at that point at 19.25, carried a spread of 3,684 bps over. "It's a whole new universe." He also said that it was "interesting that people who [before] had traditionally not played in financials, have now been forced to take a look."

Traditional distressed financials better

Apart from the fallen high-grade financial names, a trader saw more traditional distressed junk financial names mostly riding the crest of the higher wave on Friday.

He saw Residential Capital LLC's 6½% notes due 2013 push up to 24 bid, 28 offered from Thursday's levels at 20 bid, 24 offered, although another junk mortgage name, Thornburg Mortgage Inc.'s 8% notes due 2013 were unchanged at 58 bid, 60 offered. He saw MBIA Inc.'s 14% surplus notes due 2033 - technically investment-grade rated but trading in the junk market, at usually lower levels, almost from the moment of their issue in January - as having jumped 6 points on the bid side to 83 from 77 previously.

A trader said that real estate services operator Realogy Corp.'s 11% notes due 2014 were "potentially really big movers," pushing up to 46.5 bid from 41 the day before, on volume of $12 million.

Non-financials share in the volatility

Apart from the faltering financials, a trader said that Harrah's paper traded, and Ford Motor Co., "and even in that stuff, the swings are pretty remarkable." He said that while the Fords "kind of hung in within a 2 point range, while Harrah's had a 3 or 4 point swing, so it's hard to tell. The one thing that seems pretty clear to me is that there isn't so much a conviction as there is people just trying to rearrange positions and be opportunistic to the extent that they can be, and play."

Interestingly, the trader said that the volatility "has all been in the higher-rated credits."

He noted that Sprint Nextel Corp. "has more volatility as a split-rated (Baa3/BB/BB+) credit, albeit in our universe, than some of the CCC stuff that barely moves."

As if to underscore that point, a trader at another desk said that Overland Park, Kan.-based wireless telecommunications operator Sprint Nextel's flagship issue, its 6% notes due 2016, moved up to 86 bid from 83.5 on Thursday, on active volume for a non-financial of $32 million.

Among the automotive names, a trader saw GM's benchmark 8 3/8% bonds due 2033 up 1½ points at 53 bid, 54 offered, while Ford's 7.45% bonds due 2031 were also up 1½ points at 54 bid, 55 offered. Another trader saw the GM benchmarks at a final round-lot trade of 54, well up from 50.375 on Thursday, and saw Ford's long bonds 3 points better, at 56.

A trader saw the Harrah's 10¾% notes rise to 61 bid, well up from Thursday's levels at 55. Then the paper "got pushed back down" to 58, but came back from their lows to end at 59.5 bid, 59.75 offered. The Harrah's Operating 5¾% notes due 2017 rose 4 points to 34, while its 5 5/8% notes due 2015 were up 5 points to 37.

Ethanol producers go both ways

Traders saw VeraSun's bonds better on the news that the ethanol producer will explore strategic options, which observers believe could include the sale of assets, or even of the whole company itself.

A trader saw its 9 7/8% notes due 2012 up 3 points at 72.5 bid, 74 offered.

Another trader saw its 9 3/8% notes due 2017 do even better, up nearly 10 points to the 43 level.

The company's NYSE-traded shares jumped 58% at one point, before coming off that peak and ending up 26 cents, or 17.81%, to $1.72. Volume of 11.1 million shares was almost five times the norm.

However, those shares had lost three-quarter of their value earlier in the week, plunging to $1.33, an all-time low, after the company began a public offering of 20 million shares - which it subsequently abandoned just a day later after an outcry from its shareholders - and said it expects to post a third-quarter loss between $63 million and $103 million.

Its bonds were meantime downgraded at mid-week by Moody's Investors Service, which cut its corporate family rating one notch to B3.

Standard & Poor's meantime downgraded sector peer Aventine Renewable Energy by one notch Friday to B. A trader saw its 10% notes due 2017 drop a point to 55. Another market source saw them ending the day down 4 points to 52.

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