WFC

Would it not be convenient to have a warning stating the probability that a troubled stock blows up? Sadly, neither the NYSE nor NASDAQ offers such a service before one decides to invest in a stock listed on their exchange. However, with a few assumptions and a bit of algebra, we can take a look at the options market to gain insight on the implied probabilities of big bank nationalization. If the government nationalizes or takes additional significant equity stakes, equity holders could be wiped out. This possibility seems real, particularly given recent comments that at some point bond holders should share in the capital losses, a scenario we envisage would be concurrent with complete or near total equity dilution.

In order to gain some insights from what the option markets are saying about such a scenario, we need to make a few assumptions, which while not 100% accurate, nonetheless give us a perspective on how the market is assessing such an event.

We start by looking at the payoffs from buying far out the money puts on a long dated expiration option. We then compare that relative to the payoff from such an investment. To keep things simple, we define the probability of equity failure as the return on the option investment, relative to its cost. So if an option costs $1.00 and its return is $2.00 (in the case of an equity blow out), we infer that the odds of such a blow out are approximately 50%. Another assumption is that if the big banks become nationalized, the equity will trade to a floor of $0.50 a share, consistent with what we have seen from AIG and Fannie Mae. While we readily admit our analytical framework is rudimentary, we nonetheless believe it provides some insight.

For our analysis we looked at the farthest out of the money strike puts (for C, BAC, WFC, and JPM), the $2.5 strike, for expiration in January 2010. We make the admittedly aggressive assumption that with a stock price below $2.5, the banks will not be viable, and that in turn will lead the equity to trade down to a floor of approximately $0.50, a stock price quite similar to what has been witnessed in the case of AIG and Fannie Mae.

 Table 1 displays the information required to understand the probabilities the market is implying about each of these firms wiping out their equity holders. The column labeled Option, denotes the Option price; Floor is the assumed $0.50 traded value if the stock breaks $2.50; Return is the $ gain from the option investment if the stock trades down to $0.50; and finally Probability is the cost of the option divided by its return.

 Table 1

 The first thing about our simple model is that it makes sense. Intuitively, Wells Fargo and JP Morgan seem stronger at this point than either Citi or Bank of America. What is more interesting is that relative to Wells, both C and BAC offer approximately twice the odds of being taken over by the government. Further, JP Morgan appears to offer the safest haven among these mega-financial institutions. It is interesting to note, that as bad as the situation appears to be at both C and BAC, they are only 20% to 25% more likely to go under than Wells Fargo. If the financial sector stabilizes, these companies may offer significantly higher upside with marginally higher risk than Wells Fargo. Lastly, while our analysis is admittedly crude, it is clear that for C and BAC the odds of them getting nationalized are non-trivial and likely to exceed 25% to 30% under most reasonable models.

As a new administration takes office, investors will be looking for companies that will benefit most from Obama taking office. Which stocks will your “Obama Portfolio” consist of? Will you load up on infrastructure, health-care, alternative-energy, or green companies? If Obama’s big plans are carried out, these are a few areas that may see a direct benefit. Karim Bardeesy from The Big Money put together a list of stocks they feel will benefit from the new administration and are comparing their “Obama Portfolio” to one created by Jim Cramer. Here we will look at both portfolios and compare their sales growth expectations to see which of these firms will be more likely to out-perform. We will re-visit at a later date to see which “Obama Portfolio” will have provided the better return.

 The Big Money's "Obama Portfolio" and Each Company's Sales Expectations

*denotes less than 5 years historical sales numbers, ** = 2 years *** = 3 years

Jim Cramer's "Obama Portfolio" and Each Company's Sales Expectations

VE Sales Growth calculated for these companies on 1-21-09