PUTS AND CALLS

the government announced that about 10 large banks need to raise more capital after being analyzed via stress tests. the answer? puts and calls.

in 1989, mellon bank was recapitalized with some good, creative work by bank managment, private equity firm Warburg Pincus and investment bank Drexel Burnham.

Mellon had too many non-performing assets on its books. the solution involved creating a so called bad bank where over a billion dollars of non-performing assets where transferred. that was when a billion dollars was real money. this improved the quality of the balance sheet on the asset side but its captial ratios where still too low.

the banks business franchise was sound, its stock price was low and the dilution of raising more capital weighed on the stock. the solution was an investor group was assembled;led by warburg and drexel and accepted puts from mellon that gave mellon the right to put X number of shares and Y price in 13 mos. mellon paid the investors by giving them calls. i dont remember the numbers but the deal is of public record and can be researched. in round numbers the investors got around 1 call for every 3-4 puts.

what this did was tell the market and the regulators that the bank had locked in contractually enough capital to get into capital ratio compliance at a price certain; but had the option of raising higher priced/lower cost capital over the next 13 months if possible. what happened was that with the certainty of the puts, the company raised more than enough capital thru a series of debt for equity exchange offers, and new offerings at much higher prices than the put prices; the puts expired unexercised; the shareholders experienced less dilution and the common stock appreciated alot and the put investors made good money from their calls.

how about the treasury or the fed issue 2 year puts to these 10 banks for common at todays market price and also preferred at an appropriate rate; get paid in calls and let the market sort itself out. i think the likelihood of a Mellon win win is highly likely