Monday, August 31, 2009

Pared 50 METPRA at $18.3/Largest % Gains Have Been in Disfavored Asset Classes

1. Pared 50 METPRA at $18.3 Today in IRA (see disclaimer): In my second post after starting this blog in October, I discussed METPRA in detail, a perpetual and non-cumulative preferred stock. In the U.S., this kind of security is sometimes called a traditional or an equity preferred stock. It is listed as part of the firm's equity, unlike the European hybrids which are listed as debt on the balance sheet while considered equity for regulatory purposes. 

I was drawn to METPRA back in October 2008 because it was selling at a substantial discount to its $25 par value, which juiced both the guaranteed and the floating rate in this instrument. 

Along with a prior sale of 50 shares of METPRA, I am now close to playing with the house's money for this security with my remaining 150 shares, taking into account the dividends paid since I first acquired shares last Fall and my profits.

2009 IRA METPRA 50 Shares +$117.97
I have mentioned previously that I prefer buying securities that pay qualified dividends in a taxable account, and securities that pay interest taxed at the highest marginal rate in a retirement account. (see, e.g. my comment to Cathie in today's post: Common Sense View of European Hybrids/Sold PICO at $33.06/) I ended up with 100 shares of METPRA in my traditional IRA since I had some funds available and the price had fallen to an absurdly low level. Averaged Down on POM/Added To METPRA/

While this type of security is deemed by accountants and lawyers to be part of Met Life's equity, the owner has no equity interest in the business. If a firm made an offer to acquire Met Life at a premium, that offer would be directed to the common shareholders. To understand what can happen, I previously gave an example of what happened to the equity preferred shareholders of Innkeepers, a hotel REIT, after it was acquired in a leverage buy out. The common shareholders received a premium for their shares, and the preferred shareholders now have a stock trading at a few cents on the dollar in what is called the Grey Market and their dividend in deferral. Late Friday Buys: LNC and GXP

So, it always important to understand what you own. METPRA is more like a bond than equity. The equity characteristic of this security embodies all of the undesirable aspects of common stock, such as its perpetual nature and non-cumulative dividend, without the desirable feature of Met's common shares, an ownership stake in the business. The preferred stock does have priority over the more junior common stock in bankruptcy and in its superior claim to dividends. For the owner of METPRA, and I still own 150 shares after the sell today, the superior claim simply means that the common dividend has to be eliminated before the preferred dividend.

I think that my discussion of this security was a good one back in October and I thought that I would copy part of it here:

"Met Life has a preferred stock issue that also took a beating last week along with common stock. The symbol is METPRA, or MET-PA at yahoo finance or MET.PRA at Marketwatch. The par value of this preferred issue is $25 with no maturity date. As of last Friday, 10/3/2008, it closed at $9.8 per share. The floating rate provision requires Met to pay the greater of 4% or 1% over three month LIBOR (the London Inter Bank rate). For 100 shares, the annual interest payment at the guaranteed rate would equal $100 (.04% x 25 par=$1)
The coupon is calculated on the par value. However, when you purchase the security at $9.8 for example, the effective guaranteed yield at that price is 10.2% ($1 divided by 9.8 cost=10.2%). Thus, a purchase at last Friday's closing price excluding a brokerage commission would give you a guaranteed yield of 10.2% paid in quarterly installments. .........

For purposes of illustration only, I would like to assume what effect a 3 month LIBOR rate at 5% would have on the MET LIFE floater. The rate would then rise to 5% + 1% or 6%. A 6% yield on a $25 par value bond like investment would yield $1.5 per share in interest per 1 share annually or a 50% increase over the guaranteed rate. Now, you need to do a calculation of the effective yield at a $9.8 cost per share. This is done as follows: $1.5 interest divided by $9.8 cost=15.3%. Of course, this yield will go up when the cost goes down; and the yield will go down when the cost goes up.

The downsides that I considered prior to making a purchase can be summarized as follows. First, the security has no maturity but Met Life could redeem the security at par value plus accrued interest in the event the float rate becomes too onerous for it which could happened with a prolonged spike in short term rates and an inverted yield curve, where Met Life could refinance with a longer dated maturity and save money. When purchasing a bond or bond like investment I always prefer issues that have a fixed maturity date. Second, this is a non-cumulative issue, which means that any interest payment missed does not have to be paid later. If missed it becomes like an eliminated common stock dividend where the company has no legal obligation to pay an eliminated dividend in the future. Generally, for non-cumulative preferred stock dividends, the company can not pay any common stock dividend and reduce or eliminate the preferred stock dividend. That is, if a common stock dividend is paid in any amount, the preferred dividend would have to be paid in full. Also, any elimination of a non-cumulative preferred stock divided would invariably be linked to a major solvency type issue. Bankruptcy in all likelihood would be just around the corner. So in many circumstances the importance of cumulative versus non-cumulative would not be material. Nonetheless, it is always better to buy a cumulative preferred stock which requires any missed payment to accumulate, sometimes with interest, and payment is not discharged short of bankruptcy. Third, a preferred stock only has preference rights in bankruptcy to assets over the common stock holders. The Lehman preferred stock issues are now worthless in that investment bank's bankruptcy. The most secure debt in the event of a bankruptcy is secured debt, like a mortgage on a building, then senior debt, then junior debt-sometimes called junior subordinated debentures, then preferred stock and lastly common stock. So the METPRA is just above common stock in this pecking order. It is however difficult for me to imagine now a bankruptcy for MET LIFE and this security does give you the benefit of a guaranteed rate plus protection in the floating rate provision in the event the short term LIBOR rate increases." LIBOR AND THE MET LIFE FLOATING RATE PREFERRED STOCK

I can not stress enough the importance of understanding what you own. A period of time needs to be spent reading the prospectus: METLIFE INC The first few sentences of most prospectuses might give you important information about the security, as does this one from Met Life. You find out quickly that it is non-cumulative and the circumstances that are required before the dividend is eliminated by the company. A perpetual bond like security with a non-cumulative dividend and a low priority in the capital structure (which is how I would describe METPRA) is something that I dislike for those reasons. It is at the start part of a disfavored asset class, which means an active trading strategy will be used for the security. Embracing Volatility as A Risk Management Tool In the Sub-Asset Class of Equity Preferred Stock Trading Rule for Disfavored Asset Class: Sold BDNPRC and Late Buy of Just 30 Pico Managing Risk for Each Security in the Asset allocation Those factors alone will cause me to turn cautious when buying it, requiring a substantial discount to par, and then limiting my exposure to relatively small sums. Since I have a more favorable view of Met Life as a company than most of the equity preferred stocks that I have bought during their meltdown phases last Fall, I am consequently more inclined to keep some shares even with a handsome unrealized profit in them due to the yields at my cost and the inflation/deflation protection provided by this kind of security when purchased at a substantial discount to par value.

2. Large Percentage Gains in Disfavored Asset Classes: One aspect noted by many long time readers, who have been reading my blog for months, rather than a few here and there, is that my largest percentage gains have come from what I view as the riskiest assets since I started writing this blog. You can stay at that kind of party too long. In fact, I think that my largest percentage gain has come from a REIT cumulative preferred, GRTPRF, bought last fall at $2.9, a $25 par value and a 8.75% coupon, which I still own after some paring. GRTPRF: A WALK ON THE WILD SIDE/ KTN add My yield is 75% per annum at my cost, with more than enough profits to pay for what is left, several quarterly coupons already received and a closing price today of $15.72. GRT-PF: Summary for GLIMCHER RLTY PFD F Large percentage gains, with many doubles, have been realized in the European hybrids and other REIT cumulative preferred issues.It is important to understand the securities, their many disadvantages over other securities, and to realize when the risk justifies the reward. Even as late as a few months ago, it was possible to buy a security like a cumulative preferred issue from S L Green at more than a 50% discount to par value and and a yield greater than 16%. Now, would I think the risk of buying SLGPRC is worth it at $20, and the answer is not for me. REIT CUMULATIVE PREFERRED LINKS IN ONE POST/Advantages & disadvantages

Maybe it is for you. But, to take the risk, you need to understand and fully appreciate the risk that you are taking with the European hybrids, particularly now, and with other securities like equity preferred stocks which have many disadvantages to them which need to be fully appreciated by individual investors prior to making an investment in them. Advantages and Disadvantages of Equity Preferred Floating Rate Securities

Another ridiculous source of percentage gains for me this year has been my Lottery Tickets. For someone like me, this is a per se disfavored asset class. Yet, I have had some of my largest gains ever over short periods of time in some of these issues, like CBG or NADX, with several issues doubling in price quickly, like DRAD and SBGI. LOTTERY TICKET PURCHASES: LINKS IN ONE POST This does not mean that I am about to change the amount invested in those purchases, currently limited to just $300 per position, because I fully appreciate the risk that I am taking and realize that I have been mostly lucky over the past few months with them. All of these types of issues, the European hybrids, non-cumulative preferred stocks, REIT preferred stocks and my Lottery Tickets, have an enhanced risk profile attached to them for a variety of reasons. With enhanced risk, there comes more of an opportunity for gains, which I have mentioned many, many times in connection with the hybrids, and also enhanced opportunities for serious percentage losses.

Maybe for new readers I need to quote a few sentences from a post in April about the ING hybrids:
"The danger in investing in any of these securities is apparent. First, ING has eliminated the common share dividend, the security blanket for a preferred shareholder. Second, ING has been hit hard by the credit crisis. In some of the above linked posts I have discussed the Dutch government's first effort to stabilize this large financial institution. ....
I have successfully reduced my risk by trading the positions at a profit, so that I now hold the lowest cost shares using FIFO accounting which is my custom for securities viewed as having an enhanced risk to them. An individual investor has to become knowledgeable about these risks in my opinion in order to make an intelligent decision whether or not to buy, how much capital to expose given the balance of risk/reward, and the method to be used to manage the risk. That judgment can not be made for you....." ING Preferred Stocks: Links in one Post

Added 10 P.M 8/31: I thought that I would attach a comment that I just made in the comment section of another post which is apropos of this discussion:

"I would add to my observations that an investor is invariably faced with a large number of choices among alternative investments. I will go anywhere and buy anything. No matter how much money you have, there is always a question of a capital allocation. Do I buy this security or that security. For example, if I told a reader that you could buy an investment grade senior bond with a yield to maturity greater than the Aegon or ING hybrids, junior securities with unlimited rights of deferral provided certain preconditions are met, which have no maturity dates, which would you choose, taking into account that investment grade bond is senior in the capital structure, with no right of deferral, and has a promise attached to it to pay the principal back whereas the hybrids carry no promise to ever pay the principal back and come with an enhanced threat of deferral caused by at least two conditions, the absence of a common dividend and the EC newly announced policy of burden sharing. Or would a gamble on the recovery of the common shares be a better use of the capital. It was not long ago that I owned the common of ING, selling the shares for over $30 and I could have bought those shares back recently at just $3. At least with the common, I have an equity share in the business. Or do I forget about that and buy my Baby Berkshire shares back that I just sold. The capital allocation decisions are certainly thick with choices." (Comment to: Common Sense View of European Hybrids/Sold PICO at $33.06/)

Or maybe I need to forget about all of that and buy a condo in South Florida overlooking the Atlantic.

Common Sense View of European Hybrids/Sold PICO at $33.06/

1. My View of European Hybrids: There are always options for your capital. I am a lender, not a borrower. Say a person comes to me, asking for a loan with a long and complex loan agreement already prepared on a take it or leave it basis. I know that this person is generally a solid credit, pays on time, but sometimes runs into a tight spot. The borrower says, by the way, I will not promise to pay the principal back unless I feel like it. I say: "Is that a Joke", a common response for the LB when confronted with something outside the realm of its comprehension. Then the borrower says that their spouse can decide when and if a payment of interest in made on the loan, even if the borrower can afford to make a payment. And, what's more, the borrower wants the right to defer interest payments anywhere from the next quarterly payment until the end of days. And, the borrower says I am not going to pay you much in interest, even less than someone who actually agrees to pay the principal of the loan back with a similar credit history. And, then with a stern look the borrower says that you can not sue me for failing to live up to one of my few actual obligations unless you hire a lawyer in the Netherlands and file suit in my native land. Then after you spend more in legal fees than I owe you and win your case, I will pay you what is owed. What is my or your response? As difficult as it is to understand, some of the self proclaimed professional investors, running large amounts of money for institutions and funds, might jump at the opportunity to lend under those circumstances.

When discussing these European hybrids, I have emphasized their negative characteristics throughout this blog. A positive for a U.S. taxpayer is the taxation of their distributions as qualified dividends, which may soon end for those taxpayers who actually benefit from that advantage now. As a consequence and for the most part with a few exceptions, I have demanded a deep concession in price before I would buy one, and then I would not buy much. And by discount I mean buying ISF at less than $5 or INZ at less than $7, AEB at $8 or less, all with $25 par values. If investors start to demand more than 10% from this point forward for any new hybrid issued by the most solid firms, and considerably more for those who may defer coupon payments as a result of this last financial crisis, then the cost of capital would be too high to remain competitive, and the far too generous terms for the borrower would have to be changed dramatically to perk any interest in buying the security at rates the institution could afford to pay and remain competitive. And by a change in terms, I can only speak for myself. I would want a term of no less than 10 years with a promise to pay the loan back, extreme limits on deferral rights, a right to sue in the U.S. to enforce the terms, and a much higher rate than most of these instruments issued in the past pay.

The RB has been saying throughout the foregoing commentary that the LB was being too harsh and rigid as usual. The RB was saying it would want to use the proceeds from the INZ sell last Friday to buy AEB in a retirement account on further weakness. LB says that the proceeds from INZ are in a taxable account and the RB replied that it did not care about that-don't sweat the details is its motto, never say never, be flexible, relax, & have some fun watching RB's favorite bungee jumping securities.

2. Already Sold Enough Into the Rally: After figuring up the total amount of funds raised by recent stock selling, netted with a small number of minor purchases, I decided that I did not want to raise a significant amount of capital now by more stock selling, and I did not want to plow the proceeds back into stocks without a pull back in prices. One important factor for deciding to refrain from additional significant selling was that the funds raised so far have been deposited in a tax free money market account earning .1% as of last Friday. In case you missed it, there was a period in front of that 1, as in 1/10th of 1%, as in $10 in interest for $10,000 per year. Instead, I will just continue to do some backing and filling waiting for a better opportunity hopefully in September.

3. Sold PICO at $33.06 (see Disclaimer): For some reason that remains unclear to the LB, the RB bought 30 shares of PICO at $29.52 even though the LB was too busy to do a proper analysis of the company. Trading Rule for Disfavored Asset Class: Sold BDNPRC and Late Buy of Just 30 Pico RB's Water and Land Story: PICO?/ Non-Confirmation Means Vix Does not Confirm a market Move After trying to get a handle on PICO's valuation or even how to value the company, the LB decided that it did not have enough information to come up with good valuation criteria for this kind of company, did not want to add to the position for that reason, and promptly sold the 30 shares over RB's strenuous objections.

Sunday, August 30, 2009

New Free Site for Trading History of Municipal Bonds/What Do All the Relevant Facts Tell You When Assembled, Reviewed and Analyzed without Bias

1. More Transparency in Municipal Bonds: One of my peeves for years has been the lack of transparency in the bond market. It was difficult to find information about particular bonds or anything resembling current trading data. The FINRA web site went a long way to providing trading information on corporate and treasuries free of charge to the average individual investor without access to a Bloomberg terminal or some other costly subscription based service. Gretchen Morgenson told me something in her NYTimes column that I did not know, a new web site has finally come into being providing data on municipal bond trades and easy access to their prospectuses. Municipal Securities Rulemaking Board::EMMA This is link to the data page for recent trades: Municipal Securities Rulemaking Board::EMMA If you click the link under "Security Description", it shows you the recent trades for that security. The tab "official statement" contains the prospectus. Like the FINRA site this one does not work properly for the Apple operating system using either safari or firefox browsers. I am always grateful to someone who tells me something that I do not know, and need to know.

2. Why Read Abelson's Column-The Hazards of Being Set in Your Ways and Opinions: I try to absorb as much information as I can by reviewing and attempting to assimilate data from original sources. I do not care about person's opinion about what the information means. Bungee Jumping Aegon and ING Preferred Stocks/ BlackJack and Stock Investing: Lessons Learned & Applied I try not to approach an evaluation of information with an ideology or worldview that will warp or distort the information to fit the pre-existing frame of reference. A commentator like Abelson will always find something to support his worldview, and will discard or minimize any contradictory information. That is a dangerous process for an investor to imitate, at least for one that has the responsibility to make the best decisions possible with the information available. Part of that process has to be sorting through information to determine reliability and importance. Sometimes, a bird like Alan will provide me with a perspective on data that will cause me to downgrade its importance or to learn more about its shortcomings when the information is positive of course. That is why I read his column and have done so for as long as I can remember. I view his approach to forming opinions as ludicrous.

Back in early March, I was absorbing the negativity in his Barrons column, mentioned in a prior post as the one published just prior to the start of the market's explosive run during the week of March 9th. The indicators that I use were still flashing warnings signals. Yet, I started to buy. I asked myself why over the weekend in a more serious vein than I use in my stream of consciousness narrative contained in this blog. My explanation at the time was that the RB has committed a coup d'etat, seized the keyboard away from the ever cautious LB, and went on some frolic and detour buying stocks for almost the entire next 2 months, in violation of all of LB' elaborate trading rules for a bear market Actually, the buying started just prior to Alan's column that weekend. The buying is summarized in the posts from March and April:

In retrospect, one factor that was probably critical in the change of heart, though I did not fully appreciate its significance at the time, was the chart referenced many times by me from the NYTimes which showed the S & P index, adjusted for inflation, using a 10 year average earnings, a favorite benchmark used by Professor Shiller in measuring valuation. I looked at that chart when it was originally published on March 14th, and just said to myself that is low enough for me. Others would look at the chart, refer to some past event when the market bottomed at a 7 P/E using this formula and wait for that number, or some other number lower than what turned out to be the bottom, still waiting now for that opportunity no doubt.

I had already started to lean in the direction of "that is low enough for me", which explains some modest buying before seeing that chart. The chart on housing prices also showed me that the bubble in pricing had largely been corrected by March. That was viewed as important. (page 2 of the article).

The first initial wave of buying on March 6th was timid, but important considering the flow of bad news. Buys of JWF KSA DIS and NYX/SOLD Entire Position in TFI/ Just a Day of Ignoring My Own Rules This sort of broke the ice, the rigidity that sets in when a human is scared, sometimes referred to as that deer in the headlights look. For a few weeks, I had been selling some bonds. Now, I was going to move all of those funds into stocks and higher yielding corporate bonds. On the following Monday I bought 50 MJH at $7.51 while noting continued negativity, Buy of 50 MJH at $7.51/ Pop in My Animal Spirits Balloon/Japan/ Zulauf/CNBC/Meet the Press. Later that day, March 9th and continuing for the week, I shifted into higher gear without saying why really. Buys of CPB LQD SYY XKK/Regressive Taxation-Cap & Trade/; Buy of 50 JZV at 9.93/Movement in Aegon and ING Preferreds: More of A Reflection on the Human Psyche; Buy of KO at 38.72/N Buy of 50 NADX at $1.27 BUY OF KXI Buy of HNZ at 31.67 This was the explanation given at the time: Right Brain Still In Control: Acting on "Feelings" and "Instincts"

Whatever, the buying continued in the next week with adds of Uniliver, the Ishares for Canadian stocks (EWC), Brookfield Asset (BAM), Ebay, and DKF (a TC with a Goodrich bond). In the following week I started to note what later was called "green shoots". By now, I had read the NYT article, and went into higher gear with a much larger movement into individual stocks, followed by additions to stock mutual funds, and the purchase of several stock ETFs. Some of thoughts for delving deeper were expressed in a post which was critical of those who value companies based on the worst possible year, as if nothing will ever improve again: Tribe on Impairment of Contracts/Alexander & Baldwin/Stock Rallies and Quantitative Easing The Forsyth column in Barron's about the impacts of quantitative easing was also important to buttress what I was doing.

Reading those posts again, I was struck by the increasingly positive tone of the news in the weeks following early March even while noting the negative. When an investor frees their minds of biases that warp the processing of information, then the focus becomes what is the relevant data telling me about what is happening. If the news is bad, I want to know. If the news is improving I want to know that too. I do not want to cherry pick data to support a rosy view or a dour one. In the last analysis I started to buy because equities had become too cheap when viewed on a normalized earnings basis. The financial crisis had been effectively addressed by the governments and central banks around the world. In March, Armageddon was already off the table. The major financial firms were not going to be allowed to cause an implosion of the world's financial system. The lessons learned from the Lehman failure had been learned and applied. Hopefully, when we all look back on March 9th, it will be seen as one of those rare buying opportunities that comes along infrequently in one's life. The perennial pessimists of the world will never be able to seize that opportunity. And, the giddy ones, this time is different crowd, who discards the tried and true techniques for valuing companies circa 1999 or real estate (2004-2007), will not be able to anticipate the likely course of events when reality pops the bubble created by them.

More On Deferral Issues: Aegon & ING Hybrids-Investors are not Helpless before the All Powerful and Knowing EC

Sometimes I want to elevate a discussion contained in the comment section of this blog into a post, particularly if there are a number of readers interested in the topic. The following discussion was made today in response to a comment from a reader in the Netherlands:

"DutchPerplex: I think that the emphasis has to be on paragraph 26 rather than the footnotes (fn. 34: Merely announcing the policy will cause the deleterious results which the EC professes to comprehend in the footnotes.

Of your two Dutch firms, I would view Aegon to be in better shape than ING to avoid a deferral for a number of reasons. ING is into state aid much deeper than Aegon. The amount of the aid is higher at 10 billion Euros vs. 3 billion for Aegon, but ING also did a subsequent arrangement where the Dutch government guaranteed some Alt-A mortgage loans, called liar loans in the U.S. That is, the borrower states their income and the mortgage originator says I believe you. Moreover, Aegon is further along in paying the State back. And the argument that AEG has already triggered a mandatory payment event until March 2010 is a good one, due to its payment on a Junior Security in May 2009 (plus the argument for a 4 quarter mandatory payment linked to buying any junior securities which AEG said it intends to do in Dec)

A lot may depend on the earnings for the next quarter. A good recovery in profits would alleviate some of the pressure for deferral.

I do not see a strong connection myself between the burden sharing policy, where junior bond holders have payments deferred even when the firm has the ability to pay and is otherwise solvent, and the EC policy of promoting fair competition by looking hard at state aid. I do not see the connection between the fair competition goal and paragraph 26. If there was some concern that state aid in the extraordinary circumstances of last Fall was too generous, then dictate changes in that aid package. But the terms were not too generous. They would not distort competition. After all 8.5% is not a low rate, and ING has to pay a 50% premium to buy back the State's shares. In short, it was not state aid that would distort competition under the dire circumstances from last year.

Thus, the EC policy aimed squarely at junior bond holders is more of a penalty than an implementation of any policy objective in my view.

In the U.S., the source of the problems, there was never an official burden sharing policy for debt holders, let alone an attempt to implement one, and the EC has already done both ( e.g. KBC & Allied Irish). Even the disasters like Fannie and Citigroup have kept paying interest on their bonds, even the most junior ones. The intervention of the EC into a boardroom type of decision based on what I view as a primarily political decision, with at best a tenuous connection- if any- to any EC policy objective, makes all hybrid securities less desirable for investors around the world. For me, I have said many times in my blog that I had an unfavorable view of the hybrids due to the lack of a promise to ever pay the principal back, and then they have these liberal deferral provisions with no maximum time limit on deferral. The U.S. Junior bonds will typically put a maximum of five years on a deferral.

There is an alternative payment mechanism in the Aegon prospectuses where AEG would sell common stock to pay a deferred dividend. The Fitch analysis said that the EC might look more favorably on using that method to make a payment rather than using cash on hand."

I would hope that any deferral on the hybrids by either ING or Aegon for the December quarter is met with the immediate filing of a lawsuit. This needs to be done with a thunderbolt and not a whimper. The position that I have outlined of four mandatory payments triggered by the payments on Junior Securities in May 2009 is a good faith position that needs to have its day in court in the event of a deferral for the next quarter payments. Contrary arguments would undoubtedly be made, and that is why we have a judicial system. A deferral caused by the EC in implementing its burden shouldering policy has to be met immediately with any and all courses of action in the judicial system. My purpose for writing these blogs about the possible Mandatory Payment Events for Aegon and ING is to show others that we are not helpless, we do not have to take it lying down, a good fight can be waged and even won.

The best and clearest case would be the purchase of a junior security during what is clearly now an annual payment period for the Junior Securities.

It has to be remembered that the payments on the Junior Securities in May 2009 were for a short period, roughly a semi-annual period, from the time the agreements were executed by the parties to May 2009. So, the contrary argument would be to match up two quarters for the hybrids with the roughly two quarters of the annual period for which payment was made in May 2009 on the Junior Securities. Now, both the Junior Securities issued by ING and Aegon in connection with the bailout last year are in annual payment periods.

Another point is that these hybrids will soon become less appealing to those considered to be "well off" by the the Democratic Party. Currently, the ING and Aegon hybrid distributions are taxed as qualified dividends subject to a maximum 15% tax rate (Preferreds eligible for the 15% Tax Rate Table - site registration required). It would be reasonable predict that in 2011 or sooner that this will change for the well off American taxpayer. Then, one of the primary reasons for owning them will evaporate. When you add to that the EC burden shouldering policy for the hybrids, the lack of a maturity date, no time limit on deferrals, and a liberal deferral provisions, why on earth would anyone in the U.S. in the well off tax bracket want to own them.?

Saturday, August 29, 2009

Summary of Arguments To Stop EC from Causing Deferral of Payments on the Aegon Hybrids/Shiller/Abelson

1. Abelson's Barrons Column from March 9, 2009: I thought that I would go back and read Alan's column from the weekend just prior to the market's 50% or so spurt. Alan was on fire with negativity, and quoting none other than David Rosenberg who, according to his pal Alan, was "firmly convinced that the 'worst' has yet to be priced into the market". David and Alan were still negative after a drubbing of 56% from the peak. I am not convinced either of them would have turned bullish with a DJIA at 32 (1932 low) in March or even at ZERO. Some people are just like that, nothing changes for them, the class is forever empty or filled with raw sewerage even if it looks crystal clear and certified by multiple independent labs as safe to drink. At some point, the perennial pessimist starts to look ridiculous.

2. Professor Shiller's Valuation Measure: In the intelligent investor column in the, it was mentioned that Professor Shiller's preferred measure of valuation, average earnings over 10 years adjusted for inflation, has risen from 11.7 in March to 18.4 times, with the long term average at 16.3. This is a chart from the NYT in March that shows a chart using that criterion from the early 1900s to March. NYTimes The 10 year data is going to be influenced significantly for the next 2 to 3 years by having earnings from two recessions, the one occurring between 2000-2002 and the Great Recession starting in October 2007. Shiller would have missed the rally since March. Shiller said he was not ready to invest in stocks in February, wanting this 10 year adjusted p/e to fall below 10. Shiller Stocks Not Yet Cheap Enough for Me I do believe, however, that caution is the watchword when the number approaches 20, so I may start to do more paring soon.

3. Summary of Arguments to Stop EC from Causing Deferral of Payments on the Aegon Hybrids:

A. The key is classifying the securities issued to Aegon's majority shareholder in December 2008 as "Junior Securities" ( Junior Security) to the hybrids. I would just be shocked to find out that those securities, which are pari passu (Pari-passu) with common stock, were not Junior, for the reasons discussed below.

B. Aegon made a "payment" to the majority shareholder on those Junior Securities in May 2009.

C. The Junior Security is an Annual Payment Security.

D. A Payment on a Junior Security Triggers the Mandatory Payment Event in the Aegon hybrid prospectuses.

E. The number of Mandatory Payments depends on classifiying the Junior Security as paying distributions Annually, Semi-Annually or Quarterly.

F. A payment on a Junior Security that pays Annually would trigger 4 Mandatory Payment Events for the hybrids.

G. This would consequently require payment for the quarterly distributions in June, September and December 2009, and March 2010.

H. If Aegon buys Junior Securities from its majority shareholder in December 2009 as it plans to do, this would trigger a Mandatory Payment Event.

I. If the Junior Securities are purchased after 12/15, the Mandatory Payments on the hybrids would be for the entire 2010 year.

All of the foregoing arguments are based on my interpretation of the Mandatory Payment clauses in the prospectuses and the classification of the securities issued to the majority shareholder as Junior Securities to the hybrids and those Junior Securities pay Annual distributions within the meaning of the Mandatory Payment clause.

These arguments are discussed in these posts:

The agreement between Aegon and its majority shareholder: Exhibit 4.11
The prospectus language on Mandatory Events in the hybrid AEB at p. S-22
AEV: at p. S-21
AED at p. S-20:
AEH at p. S-21:
AEF at p. S-22:

Based on what I know now, the EC is not trying to cause a violation of the loan covenants in order to implement its burden shouldering policy. If it did, the consequences would be disastrous for the European firms. In the U.S. a private actor (one not protected by sovereign immunity) inducing a breach of contract could be held liable for treble damages in an action for tortious interference with contracts. We take that kind of conduct very seriously in the U.S. Also, the remedy for a breach of covenants is not very good, and that can sometimes lead a party to violate a contract, knowing that the remedy is that they can only be forced to pay what is owed. This would be a disastrous choice for an insurance company wanting to sell products in the U.S.

The following is a quote from a hybrid prospectus on the ranking of the hybrids:
"The Capital Securities will be direct, unsecured, subordinated obligations and will rank equally without any preference among themselves and among our Existing Capital Securities. The Capital Securities will be subordinated to the claims of all of our Senior Creditors, present and future. Currently, our outstanding Common Shares and preferred shares are our only securities that rank below the Capital Securities and the Existing Capital Securities are our only securities that currently rank equally with the Capital Securities. All of our other securities currently rank senior to the Capital Securities." Page S-12:

This is a quote about the ranking of the shares issued to the Majority shareholder:
"Status and Subordination of the Securities

The Securities constitute direct, unsecured, subordinated obligations of the Issuer and rank pari passu without any preference among themselves. The Securities will rank pari passu with the Common Shares of the Issuer (except that the Securities do not carry voting rights) and will be subordinated to the Senior Claims (as defined below).
For the purposes of this paragraph:
subordinated to the Senior Claims means and has the effect that any claims or rights that a Holder has under the Securities against the Issuer (the Junior Claims) are subordinated in right of payment (including any prepayment, repayment, distribution, set-off or recovery, whether in cash or in kind) in respect of all claims that any creditor of the Issuer has at any time against the Issuer (the Senior Claims). If (in the event of a winding-up, dissolution, or otherwise) the amount of payments to be made under the Junior Claims is to be calculated: (i) first it shall be calculated the amount to be paid on the Senior Claims and the Junior Claims based on their statutory ranking; (ii) second the amount to be paid towards the Junior Claims based on their statutory ranking shall be paid instead towards the Senior Claims until such Senior Claims are paid in full, and the remaining amount, if any, shall be shared among the Holders and the holders of Common Shares as set out in the following paragraph.
rank pari passu with the Common Shares means and has the effect that any proceeds remaining after payment of the Senior Claims and payments on the AEGON Preference Shares (the Excess Proceeds) shall be applied towards payment of amounts due under the Common Shares and the Junior Claims on a pro rata basis (theAttributed Amount). The Holders shall not have any rights to and, shall, to the extent necessary (upon acquiring any Securities) waive their rights to, receive payment of the Excess Proceeds which they may be entitled to receive on the basis of the statutory ranking of Junior Claims vis-à-vis the Common Shares in excess of the Attributed Amount in respect of the Securities.

Page 408: Exhibit 4.11
The hybrids are listed as bonds at Aegon's web site: Capital securities - Aegon

The description of the securities issued to the majority shareholder are described as in pari passu with the common shares at Aegon's web site: Convertible Core Capital Securities - Aegon

So, I am still waiting to hear the argument that the securities are not Junior to the hybrids
Since the hybrids are foreign to us in the U.S., uniquely European, I would like to have any input from my European readers who may have specialized knowledge about these securities as to their ranking in the capital structure.

I have no reason to believe that Fitch gave any consideration to any of the foregoing when downgrading the rating of Aegon's hybrids to junk. Nor do I have any information that Moody's gave any consideration to the points that I have made about ING and Mandatory Payment Events, when stating unequivocally that there was a high probably that the EC will ask ING to defer.

Please note that a valid Mandatory Deferral Event (a solvency type issue) occurring after a Mandatory Payment Event will allow for a deferral of prospective payments during the period of the valid Mandatory deferral.

There are a couple of relevant differences in my opinion relating to ING compared to the Aegon situation. First, unlike Aegon, ING has not announced that it intends to buy back the Junior Securities issued to the Dutch State at a time certain, more like a general intent to buy back those securities. Second, on the issue of whether the payments to the Dutch State by ING are annual payments, the wording of its contract is not the same as Aegon's agreement with its majority shareholder, and I will leave it with that observation. ( Compare Exhibit 4.11 with exv2w10)

Friday, August 28, 2009

Sold 1/2 INZ (see disclaimer)/ING Paid the Dutch State in May 2009

One of readers, michaelandfred, pointed me to the ING quarterly report for the second quarter where ING made the following statement:

"As previously reported, since an interim dividend
on ordinary common shares was paid in August
2008, the first short coupon on the core Tier 1
securities issued to the Dutch State was paid in
May 2009. "

This document can be found at Quarterly Results - ING

You would click the PDF for the Quarterly Report rather than the PDF for the Press Release.

This payment was made on a security in pari passu with the common shares : "The securities are pari passu with ordinary common equity meaning the Dutch State will rank exactly the same as common shareholders."ING to strengthen core capital by EUR 10 billion - ING Any payment on a Junior Security to the ING hybrids triggers a Mandatory Payment Event. Is there anyone claiming that the shares issued to the Dutch state are not Junior Securities to the hybrids? If there is somebody, please state your reasons in the comment section.

The only issue becomes then whether such payment triggered four mandatory payments or two. Nail on the Head for Aegon Mandatory Payment Event? That resolution will depend on whether the Junior Securities are classified as paying distributions on an annual basis or a semi-annual basis.

My involvement in writing about this subject is due to reader interest, and I do not particularly care for the EC burden sharing policy. I view it as idiotic, counter-productive, and made in bad faith. I would like to do whatever I can to muck up their plans. And I think that I am making progress toward that goal.

My positions are: 200 IND, 350 AEB, 50 ISF, 100 IGK, 100 before today of INZ, and I forgot how much of AEH.

Since I have decided to pare back my small holding in European hybrids, due to my extremely negative view of current events layered on top of my negative opinion held for years about these securities (e.g. no maturity date), I sold late today 1/2 of my INZ at $14.60 (see Disclaimer) which were bought in the taxable account at $6.52 in February. Hartford Bond Sold/ Modoff: No Evidence of Trading/bought 50 INZ at 6.52/ It was ex today so that was a good profit on the shares of more than 100% plus some dividends.

My current thinking is hold the Aegon hybrids, and pare the ING hybrids only in the taxable account, keeping the ING hybrids held in the retirement account due to the avoidance of tax issues in a retirement account resulting from a deferral of a cumulative dividend. This of course may change with some new negative development.