Monday, November 9, 2009

FDIC Preference Rules for Seized Banks/EWBC/Bought 50 of the TP ABWPRA

1. Bank Trust Preferred and the FDIC Preference Rules: Given the failure of a large number of banks since the onset of the Near Depression, I wanted to revisit briefly an issue mentioned throughout this blog, the increased risk of owning bank debt due to the FDIC preference rules applicable upon seizure of a failed bank. It is important to keep these rules in mind particularly when the banks are under a lot of stress as now.

The Cleveland Federal Reserve published a paper in 1994 explaining the changes in the FDIC preference laws that gives all depositors a superior claim on a failed bank's assets compared to other general creditors. Even uninsured depositors stand above unsecured creditors, including senior debt holders.

I would simply ask the reader to reflect on this preference rule for a moment. The FDIC has just seized a bank. Why? The bank has failed. The bank is insolvent. And, the FDIC is most likely going to take a loss. Why would an owner of a junior debt holder expect to recover anything under those circumstances? Now, the FDIC is going to incur expenses in liquidation and those expenses come first. Some creditors will have secured claims. Then the depositors within the insurance limits of the FDIC have to be made whole. Then, whatever is left has to be used to satisfy the claims of the uninsured deposits. That is the death knell for the claim of the junior debt holder in my opinion. Given the FDIC preference laws, I operate under the assumption that any unsecured debt from a bank is more risky than debt of similarly rated non-bank debt. There is at least a possibility of recovering something in a bankruptcy of a non-bank, even for the junior debt holder. I would be curious if anyone has ever recovered a penny owning a bank junior debt security after its seizure by the FDIC.

The bank Trust Preferred (TP) is in essence a junior debt issue, and is to be distinguished in that regard from regular preferred stock that is a form of equity. Regular Preferred and Trust Preferred After a bank seizure, it will stand in the chain of priority above the common and equity preferred stock, but below everything else include the claims of all depositors. {this is a link to the Federal Deposit Insurance Company Act and the priority rule is set out in (11): FDIC Law, Regulations, Related Acts - Federal Deposit Insurance Act Section 11 (d) (11)}

The fear of an FDIC seizure drove the Trust Preferred issues of many large U.S. financial institutions down to the low single digits during the darkest days of the Near Depression. While it can be argued that this price decline was overdone, it was not irrational under the circumstances. Just look at the price charts of some of the Trust Preferred issues of Bank of America, all show similar declines: BAC.PRB Stock Charts - Bac Cap Tr X CAP SEC 6.25% Stock Charts During February of this year, BACPRB, just as an example, could have been bought for $6, a typical $25 par value TP. At a coupon of 6.25%, the yield at a total cost of $6 would be 26%. But, with that kind of risk, there is also an enhanced opportunity to make money. One foray that I made into this area during the meltdown was to buy a Trust Certificate containing a Bank of America Trust Preferred, MJH, that will give me close to a 25% annualized yield based on my cost of $7.51 Buy of 50 MJH at $7.51 But that kind of buy was not exactly vigorous. In retrospect, notwithstanding the heightened risk associated with bank TPs, particularly under the circumstances prevalent a few months ago, many of them presented once in a lifetime type opportunities when they were priced to yield over 20%. Now, the Bank of America TPs have more than doubled in price off those February lows, and are now priced to yield around 8.5% -8.75%, give or take depending on the issue.

I always keep these FDIC preference rules in mind when deciding how much capital to deploy to bank TPs. The Old Geezer will always look at the downside first, before even considering the potential upside.

2. East West Bank: One beneficiary of a bank's failure is sometimes the bank that takes over the failed bank's depositors and assets. United Commercial Bank was seized by the FDIC over the weekend, and EWBC ended up with the assets and a loss sharing agreement with the FDIC on the bad loans. EWBC, which is owned, is up almost 50% early this morning. EWBC Buy of 50 EWBC as Lottery Ticket My attitude on the bank Lottery Tickets is to let them run, or to sell them once it becomes clear that failure is a real possibility. So, even though I have over a 100% gain in some of them so far, including EWBC based on today's price action, I am holding them as a group hoping for larger percentage gains over the long term. This is basically a repeat of a strategy employed during the last near death experience of the U.S. banks, the 1990-1991 period, which was followed by a long term bull market in bank stocks. There is certainly no guarantee that history will repeat itself. But, at least this earlier period provides enough of an analogy to form a Lottery Ticket strategy based on the earlier history.

I do expect some of the bank LTs to fail. And a few like HBAN and SVN have gone down some since my purchase. So, to pay for the failures, I need to maximize the returns for the winners by holding for five or more years, possibly even a decade or more. I am going to continue buying the bank LTs and may add one later today.

3. Bought 50 of the TP ABWPRA at $21.04 (see disclaimer): This is a TP issue from ASBC Capital, a Delaware trust formed by Associated Bank (ASBC). Par value is $25, the bond matures on 6/15/2032, and the coupon is 7.625%. The underlying security in the Trust is a junior debenture issued by ASBC. At my cost, the yield is about 9% with distributions paid quarterly. This is a typical bank Trust Preferred issue: Distributions may be deferred for up to five years, but are cumulative. And, interest will be accrued at the coupon rate on any deferred distributions. The stopper provision is typical (see p. S-3).

I was familiar with this bank before I purchased the TP. The bank actually earned money in the third quarter. exv99w1 IT operates primarily in Wisconsin, and parts of northern Illinois and eastern Minnesota. The bank is paying a cash quarterly dividend of 5 cents per share, which is important under the stopper provision: exv99w1 Since this is a bank TP I will be cautious on the amount of money deployed to buy shares.

I did use a market order today when the spread narrowed to 4 cents. After I entered the order, the spread increased to 19 cents, which is too much for me to enter an odd lot market order. At the time of the post today, the bid was 21.01 and the ask was 21.2.

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