February 2010, Institutional Investor

Well into the third year of the financial crisis, many large-cap bank preferred stocks have defied expectations. Instead of having their dividends suspended, as many industry observers expected in the wake of the most severe market turmoil since the Depression, virtually all of the “too-big-too-fail” banks that are still around have kept paying their dividends on their US-traded preferreds. Even Royal Bank of Scotland–the poster child of the banking crisis, which has racked up the largest losses in British corporate history–hasn’t missed a payment through 2009.

To some, like Barry McAlinden, preferred securities analyst at UBS Wealth Management Research, large-cap money center banks that have survived the crisis have treated preferred shareholders more benignly than one might’ve imagined. “While this doesn’t legally alter banks’ capital structure, it has implied–so far–that preferred stocks may offer greater returns with less dividend suspension risk than we had thought, especially given the severity of the crisis. And in 2009, the results have been common equity-like returns from large-cap investment-grade bank preferreds.”

While the banking crisis isn’t over, the sentiment entering 2010 is a cosmic turnaround from the dark days of March 2009. “For the first time since the 1980s when preferreds started to become a major source of capital financing, these shares got pummeled indiscriminately,” observes Dan Campbell, the former head of hybrid capital securities at Merrill Lynch and Deutsche Bank. Despite being income securities whose prices typically move in response to interest rates, credit issues, and yield spreads, Campbell has seen many bank preferreds track common shares, as fears of insolvency, reorganization, or nationalization brought their values to unprecedented levels.

For example, venerable Deutsche Bank saw its $25 par trust preferred [Ticker: DUA], which is actually backed by subordinated debt, paying a coupon of 6.375 percent, collapse from $20 in the middle of 2008 to below $5 in early March 2009. At that moment, it was yielding nearly 32 percent. Investors who did not buy into the “end-of-world-scenario” made out like bandits. DUA shares have since soared, trading at year’s end around $22.50.

While extreme opportunities like these are long gone, there is still significant dislocation in the preferred market, which makes it one of the most attractive places in which to invest, according to William Scapell, head of fixed-income at Cohen & Steers.

Until recently, preferreds had typically been rated two notches below senior unsecured debt, simply reflecting their placement in corporate capital structure. “Today,” says Scapell, “we are seeing much greater rating gaps, even involving trust preferreds that are cumulative and which mature. And this is putting further pressure on preferred prices.” For example, Citigroup’s senior debt is rated “A” by Standard and Poor’s. But its hybrid preferreds are rated 8 notches lower at “B+”.

This is producing yield spreads above Treasuries that have remained very high. In late December, the BofA Merrill Lunch Fixed-Rate Preferred Index of investment-grade securities was 400 basis points above 10-year Treasuries. To Scapell, the market is anticipating Treasury yields will likely rise and investors are still viewing preferreds as risky. Though he expects significant volatility going forward, he believes financial conditions of major money center banks will continue to improve. “I don’t expect a second wave to hit these institutions because the toughest news is already behind us,” he explains, “capital and provisioning looks adequate, and these banks are generally shielded by their revenue diversity.”

But the most intriguing opportunities are corporate actions that are tendering cash, common, or new preferred shares for existing preferreds, or even when dividend payments are being suspended.

In February, Citibank announced it was going to suspend dividends on a series of $25 perpetual preferreds. But it would allow investors to voluntarily exchange these shares for common stock. This offer was in direct response to increase regulatory focus away from Tier 1 Capital [a measure of leverage] to Tangible Common Equity [a measure of capital that can initially absorb losses and excludes preferreds].

Citi offered 7.307 common shares for each perpetual preferred share. Around the same time, the market began recognizing the government’s commitment to see the bank through the crisis without nationalizing it. This helped propel the common stock from less than a buck to $4. When the conversion took place in early summer, preferred shareholders ended up receiving more than par. Just several months earlier, these shares had tumbled below $5.

Certainly in this instance, it would seem that these preferred shareholders were effectively better off than bond holders [who didn’t receive any extraordinary boost to their bond values] and common shareholders–who saw their positions seriously diluted by the exchange, which brought no additional capital or earnings power.

Interestingly, Citi preferreds, whose dividends have been suspended [e.g., CpfP], have been trading in a fairly narrow band between $14 and $18. This particular issue closed the year around $17.50. While its volume is minimal, its price suggests that some investors think the dividend may be reinstated in the not too distant future.

In late May, Bank of America took a more transparent approach to reducing its preferred exposure through a cash tender offer for nine preferreds. For the most depressed issues trading at or below $10, BoA offered up to a 50 percent premium. However, unlike the Citi offer, BoA was not suspending dividends on the series it was tendering. Seven months later, all nine perferreds had tacked on another 20 to 35 percent. The lowest price series saw the greatest jump in price, and the higher coupon series are now trading near par.

No global bank that’s still in existence depended more on preferreds for capital or was hit harder by the crisis than Royal Bank Scotland. However, despite setting record losses for a British corporation, and with the government effectively owning 85 percent of the bank, RBS continued to pay its preferred dividends through the end of 2009–more than two years after the crisis began.

However, the European Commission recently ruled that RBS must suspend dividends on a portion of its dollar-denominated preferreds for two years because of the extensive aid the London has pumped into the bank. The decision was based purely on fairness to other banks that are not receiving aid. It is likely that absent this ruling, RBS would’ve continued paying preferred dividends. The reason, according to Brian Gonick, principal of Senvest International, a highly profitable hedge fund with a contrarian bent, is that suspension of payment places the company’s reputation in the capital markets at risk, which could be far more costly than paying the current dividends.

RBS was able to extend dividend payments on the seven preferred series [that will most likely see their dividends suspended] through the first quarter 2010. This move was likely inspired to buy RBS time to consider an exchange plan. Once dividends are suspended, such a plan cannot be effected.

Gonick thinks these suspended preferreds are very attractive plays. He likens them to “zero-coupon” bonds. Currently trading around 10, if one assumes that 10 percent is a reasonable yield by 2012 when dividends are suppose to be resumed, then this would suggest a forward price of $17. That would make holding or buying these preferreds a shrewder play than selling these preferreds and reinvesting proceeds into 8 percent yielding perferreds of Wells Fargo, JP Morgan, and Bank of America.

Another scenario is that RBS decides to exchange these preferreds for common stock. This would have to be done at least a 10 to 20 percent premium to abet shareholder interest.

If the British economy breaks down or if the bank doesn’t recover over the next couple of years, the preferred shareholders would be in a suspended state with supply significantly exceeding demand.

It appears that with western governments having tossed out moral hazard for its key money center banks, that investing in the right preferred securities could be a source of relatively high income and capital appreciation with less risk than their capital structure status would suggest.

However, despite many of these big banks returning to health, Harvard economic historian Niall Ferguson warns of remaining systemic risk: “The banking system is not only unreformed but actually worse than before, and I think that is a major cause for concern. With officials having addressed the underlying issues, the same problems will happen again.” If this does happen, the question then is, would preferred shareholders fare just as well next time?

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SIDEBAR: LOOKING AHEAD REGULATORILY

Proposals being considered by the Basel Committee on Banking Regulations suggest that the proportion of preferreds that will qualify as Tier 1 Capital will be greatly reduced to only include perpetual, non-cumulative issues. Currently, according to Flaherty and Cumrine’s proprietary database, only $46 billion of the total $238 billion in outstanding US dollar bank preferreds would then qualify as Tier 1 Capital.

If the committee’s work is codified, then it could trigger significant conversion of existing preferreds into new qualifying preferreds. However, its rules would only be applicable to internationally active U.S. banks.

Cohen & Steer’s Scapell would expect some growth in Contingent Capital preferreds. These would codify a process that already started–the conversion of preferreds into common if capitalization falls below a certain threshold. However, he believes demand for these securities may be limited. Many investors may not be able to own securities that have such conversion features.

He also expects broader adoption of a new kind of preferred [already in use in parts of Europe] where par value is systematically reduced to help absorb losses. This means that coupons would be expressed in terms of percent yields, not in absolute dollars to be paid. A lower par value would explicitly mean lower market value for such preferreds. This would further make preferreds behave more like equity and less like debt. Scapell expects the new rules to be passed in the summer of 2010. Though it’s uncertain how long it may take to go into effect in each different market.

These changes would likely require yields on new preferreds to be significantly higher. This happens whenever a new security type comes to market, says Scapell. “There is usually a period in which pricing is inefficient, resulting in above market yields before the market gets used to them.”

At the same time, traditional existing preferreds, without these less desirable covenants, would become more scarce. Demand for them would likely increase, sending their prices higher.

The growing complexity of the preferred markets, which expanded in 1996 when the Federal Reserve gave its blessing to hybrid preferreds [which altered the notion of Tier One Capital reserves by providing maturities and cumulative features] seem now to be countered by these new Basel proposals. And the addition of these new rules and securities makes it even more necessary to involve professional management to understand the various nuances of this exceedingly complex market.