Saturday, February 7, 2009

Bary on Bank Preferred Stocks/Depression or Recession/Commercial Mortgages

Goldman Sachs estimates that it would cost the government 4 trillion dollars or more to take the bad assets off the banks' balance sheets. Yah Fin

Andrew Bary's column in this week's Barron's talks about bank preferred stock in his weekly Barron's column. Barrons.comWhile I would agree with his assessment that the preferred issues from the likes of Bank of America and Citigroup are preferable to the common shares now, at least those two banks are still paying their preferred dividends in full after cutting the common dividends to a penny a quarter, the better question is why take the risk on either the common or the preferred in the current dicy environment.  These issues will be extremely volatile for some time to come, both up and down.    He does note the distinction between equity and debt preferred, which he calls regular and trust preferred which are two labels that I have used in the past also.  Trust preferred is a junior form of debt where the interest payments would be taxed at ordinary income tax rates, whereas regular or equity preferred would be taxed at the 15% preferential rate reserved for dividends, just like a common share dividend.   He also notes that investors have started pricing the two forms of preferred stocks differently, with the equity preferred priced for a higher yield than the trust preferred.  I noted this in a prior post.  Financials: 3 Strikes and Your Out/CISCO/Regulations and Conservatism   His explanation for this fairly recent price action is that investors want to be senior to the government's preferred stock which is the most plausible explanation.   I believe the government preferred stock is equity preferred but I have not confirmed it as stated in a prior post. If anyone finds an executed agreement between a bank and the government on the issuance of preferred stock to the FEDS please let me know   The bank trust preferred is more senior to the equity or regular preferred.  The bank trust preferred issues are generally cumulative, which would also account for their better pricing (higher price, lower yield) now compared to the equity preferred issues which are generally non-cumulative.  If Bank of America eliminates a non-cumulative preferred dividend, it is just gone.   It is important to keep in mind the non-cumulative nature of these equity bank preferred issues and that the main limitation on their elimination is the payment of dividend on the common stock, which limitation is also applicable to the trust preferred issues.   Both Bank of America and Citigroup, the two mentioned by Bary in his column, are down to just a penny a quarter in common stock dividends.  I discuss these issues and more in numerous prior posts and the following is just links to a few of them: 
I own only 50 shares of an equity preferred stock issue of Bank of America that is a floater, BACPRE, and shares of a trust preferred that is the J P Morgan underlying bond  contained in PYV,  which matures in 2014.  Most of these securities are probably more suitable to traders and speculators at this moment in time. I did realize close to a 80% very quick gain in KEYPRA in the 4th quarter 2008 and that is not what I would call a soothing experience when prices start jumping around like that-why, because they could just as easily go down 80%.(the sell:  TAX LOSS SELLING TODAY and the buy: KEYPRA)

There are those who are already stepping forward to argue that bonuses are necessary to keep the "talent" in the financial firms.   I am not not exactly sure what the author means by talent.  Does he mean the large number of individuals who believe that they are entitled to millions of dollars for risking other people's capital and not doing it very well?  In fact, a good case can be made that the financial titans and wizards, as a class, have destroyed more wealth than they have created  and are consequently worth less than zero.  When you look at in that manner, the financial firms bear a striking similarity to airlines.  There are periods that are profitable and everybody thinks that they are geniuses worth a thousand times their weight in gold.   Then the losses come and the firms go poof, just a poor hapless victim of extraneous forces that no one could have foreseen or so they say.   Yes, of course there may be some traders at Merrill who made a few million for the firm in 2008 but what about the other ones, making 20 million with guaranteed bonuses, who lost 20 or 30 billion or so?  I know Bear Stearns and Lehman Brothers distributed hundreds of millions in bonuses to its employees over the years and what exactly did that money create?  In the end, those firms were worth less than zero. 

Barron's featured another prognosticator, Ray Dalio,  who believe that the world is about to enter a prolonged depression.
I would agree with his assessment that this is not an ordinary recession but the government is not treating as such.  There is a great deal of wealth that has been destroyed, trillions of dollars of loans have to be marked way down in value, and the process is likely to be long.  But I also do not believe that the 1930s or the Japan experience is a foregone conclusion, although it is one possible outcome.   IR WARNING/the Japanese Experience with Deflation/Debasement of the U.S. CurrencyTreasuries would do well for a few more years under Dalio's scenario.   I suspect that it will take at a minimum another difficult year to work through the problems created during the credit bubble. 

Some of the problems built up during the last years of the credit bubble are just starting to accelerate into serious issues, such as commercial mortgages on properties sold near the apex often with little equity and 90% financing on the inflated asset price.  Some of these kinds of problems are discussed in an article in the NYT about the properties bought from Blackstone after it acquired Equity Office Properties.     NYT
Many of those properties are worth less than the mortgages.  MaGuire Properties gorged itself on some of EOP properties in California peddled by Blackstone and it had to defer its preferred dividends as it struggles under the debt load used to finance those acquisitions.   More Comments: Preferred stock dividends, deferral rights, and taxation of income not received    Then, there was a story last week about Moody's looking at commercial mortgage pools for possible debt downgrades. | Reuters

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