Getting To Know Ratchets

You’ve probably been wondering how capital impaired firms such as Merrill Lynch, WaMu, Citigroup and others can continue to scour the globe in need of fresh capital to shore up their deteriorating balance sheets.

The key to attracting new money is a so called “ratchet provision,” which reduces the risk for the party investing the funds. Mish at Global Economic Trends explains it this way:

The investors in the equity raise would have their investment “protected” by a provision which states that should the bank afterwards raise money at a lower price than what they paid, these investors would be compensated retroactively by having their initial investment priced at this lower price, thereby being issued new shares for free.

It doesn’t take a mathematician to see how these provisions can result in massive dilution should the bank subsequently raise even a paltry amount of capital. A new offering will trigger a lower price because of the dilution it would cause, which would trigger even more dilution because of the lower price, which would then trigger an even lower price because of the even higher dilution, etc. This is why we call such securities a death spiral.

There is no question that these companies probably have very good reasons, maybe desperation is one of them, to get involved in this kind of capital raising effort. Whether shifting into that kind of survival mode will have long-terms success or is simple just a short-term fix remains to be seen.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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