Taking Stock / El Al for Sale, Leverage Included

Yes, 180 percent in two days, and you didn't get in.

Market players still can't get over that phenomenal return on El Al's offering. Only 1,700 orders for stock and options were placed at the airline's maiden flight on the stock market. Thousands of investors, speculators and traders were left on the ground, ruing the day they spurned the carrier.

Market animals still can't understand how El Al's securities did so well on the market. It's a company notorious for its profligate ways, a chronic money-loser, laden with debt and trouble. Mainly, it operates in an industry where even the high-fliers, the biggest and the best, struggle to create value over the years.

So if the company is such a lousy one, why did its stock and options climb like that, making it one of the most successful offerings in the history of the Tel Aviv Stock Exchange?

The simple explanation is that its securities were going cheap. The underwriters couldn't package its story to the capital market, institutional investors snubbed the airline, speculators giggled and remained wary, and the offering closed at the minimum price.

But that explanation is lacking. It fails to answer the underlying conundrum: whence the sudden interest in El Al after the offering?

Indiscriminate lending spree

Here is another explanation.

The flood of circulars, new drafts and directives that the Bank of Israel's Supervisor of Banks has been disseminating reflect the lessons learned by the central bank from the banks' lavish and indiscriminate scattering of credit, and the leveraged buyouts that characterized the late 1990s. One by one, major Israeli companies had been sold off to tycoons and conglomerates that borrowed tremendous sums to finance the acquisitions.

But while the Bank of Israel sat by passively, at most failing to stop the extravaganza in time - there was one no less distinguished party that took an active part in the gala. That was the state of Israel, which was a party to the deals by privatizing government companies.

The most extreme example is the privatization of Bank Hapoalim. The State of Israel sold the controlling interest in Hapoalim, Israel's biggest bank, to a consortium headed by the Arison and Dankner families, for about NIS 5 billion. But the Dankners brought barely a penny of their own money to the deal. They borrowed the entire amount from Israel's second biggest bank, Bank Leumi, which ... belongs to the government.

As Israel slid into recession and the banks' profits collapsed, the Supervisor of Banks has been forced to broadly hint that the banks should stop giving dividends. The corollary was that the Dankners were unable to service their loans taken to buy Hapoalim.

Therefore: The Dankners partly control Bank Hapoalim, and can enjoy the tremendous clout, influence and prestige that status proffers, but the one bearing the risk is the state-controled bank that lent them the money.

Meaning, the Bank of Israel and the entire people of Israel are sharing the risk of the deal. Even though Bank Hapoalim was privatized, in practice we cannot afford to let the Dankners fall together with their investment.

The Supervisor of Banks learned the lesson. The next time an Israeli bank or government company or any other major concern gets sold, he will intervene directly and demand a major contribution of shareholders equity.

The banks also learned the lesson, at least for the moment it appears that way. In recent months they've been demanding that their customers provide a greater proportion of equity before agreeing to finance buyouts.

But the finance minister is upset. The pressure on the watchdog and bankers strengthens the stability of the financial system. It suits the finance minister rather less, though. He wants to sell the government companies as fast as possible. But without the leverage of the banks, there aren't many buyers for the government corporations.

Which brings us back to the El Al offering. How is its sale different from that of all other government companies? Its sale is different because it went at a silly price, because of the tremendous debt on its shoulders.

But you could look at it another way. In previous privatizations, the buyers had to borrow prodigious sums to buy the companies, while in El Al's case the government sewed up a deal that had been leveraged in advance. Or, as they say - the leverage was already inside, in the company, not in the buyers' financing package.

From the perspective of the buyers the result is the same. The Dankners took over Bank Hapoalim without bringing money from home, and the Borovitzes and other players that bought El Al stock and options have an option to become involved in the company's management for peanuts.

Incidentally, the Borovitzes don't have to wait until exercising their options to gain a sway over El Al. The fact that the family may become a controlling shareholder is expected to reduce El Al's enthusiasm for attacking the smaller airline, Arkia, that the Borovitzes own.

Take a company with tremendous financial leverage, with securities stuffed with financial leverage - the options, and you get assets with tremendous inherent volatility.

The basics of financing determine that the riskier an underlying asset, the greater the value of its options.

And when you package a giant, dangerous, leveraged company like El Al with a large amount of options, the bizarre result is that much of the value of its securities derives from the high risk, not the inherent value of the company.

But options must ultimately bend to the laws of economics, when they approach expiry, and when it becomes apparent whether El Al will pass to private hands, or remain in the government's lap.

If the company's operations pick up, its securities could become valuable. If its business continues to amble along, they may decline to the value of options at an unexploited expiry: zero.