Bought 50 MSPRA at 15.7/Unfunded Pension & Disability at State & Local Governments/Added 50 KTX at 25/Yamada Interview

1. Pensions and Disability: While reading a front page story in the NYT about how police in Yonkers pad their pensions, I was reminded of an earlier series of stories in the NYT exposing the disability farce at the Long Island Railway, where almost 98% of retiring workers were awarded disability, and a large chunk of those payments were funded by Social Security. As you would expect, the union for the railroad workers defends the awards.

In today's story about police pensions, there was a focus on how certain police officers would start to work as flagman for Con Ed shortly before retiring in their 40s. While Con Ed paid those officers, their overtime would be tacked on to the base pay in determining their pension payments for the remainder of their lives, and I would assume the lives of their spouses. In many cases, this padding would result in their annual pensions exceeding their salaries at the time of retirement. Con Ed does not want to hire them, but is required to do it by the City.

This sort of thing is occurring at a time when numerous state and governments, in dire fiscal straits, are laying off teachers and other active personnel.

The NYT helpfully provides a list of those persons receiving the highest pensions in New York. I thought that it was odd that they were mostly teachers, with an annual pension hitting $316,245 at the top.

When you read stories from around the country discussing this type of issue, it is impossible to draw any distinction between the Greek government and our state, local and federal governments. Eventually, promising vast sums of borrowed money to a rapidly growing number of government workers will end in a financial disaster. The USATODAY recently ran a story about how the total number of federal employees making over a $100,000 per year grew by almost 400,000 during the last recession. Early retirement with a boatload of benefits for life is of course available to them.

Forbes ran an article earlier in the year about the growing unfunded pension liabilities of state and local governments. Forbes also provides an interactive map of unfunded pension liabilities by state. The PEW Foundation issued a report earlier in the year estimating that unfunded state retirement benefits currently exceed 1 trillion dollars. pewcenteronthestates.org/.pdf

2. Bought 50 of MSPRA at $15.7 on Friday (see Disclaimer): I mentioned in a recent post that I intended to buy back some of the equity preferred floating rate stocks with guarantees. Item # 4 Added 100 BDF in the Roth at 17.1/Bought $1500 CAD/Bought 100 SJV at 9.67/LTD With one notable exception (SCEDN), the exchange traded equity preferred floaters are issued by financial institutions. That fact, along with their many disadvantages, make them particularly volatile on the downside during periods of market stress. It was not long ago that I sold 100 shares of MSPRA at 21.43, having bought those shares in May 2009 at $12.88. Bought MSPRA

I do not want to take the time to discuss the basic characteristics of this type of security, and would just refer any new reader to this earlier post: Advantages and Disadvantages of Equity Preferred Floating Rate Securities. One of the advantages, the payment of qualified dividends, may go away after this year: Dividend Tax Rate in 2011?

MSPRA is an equity preferred stock (also called traditional preferred stock) issued by Morgan Stanley. There is a lot of headline risk associated with investment banks now, along with uncertainties in future government regulation of the financial services industry. Those factors are just adding to the downward pressure on the non-cumulative equity preferred stocks originating from financial institutions.

MSPRA is non-cumulative and perpetual, two undesirable characteristics in my opinion. It has priority over common stock and is junior of course to all bonds. In the event of a bankruptcy, I would be shocked if it had any value whatsoever.

On the bright side, the fall in price to $15.7 increased the value of both the guarantee of 4% and the float provision, when it becomes the applicable rate. The main advantage of this type of security is that it provides a measure of inflation and deflation protection in the same security. The deflation protection is the 4% guarantee on the $25 par value which is worth 6.37% at a total cost of $15.7. The inflation protection is in the LIBOR float provision. This security pays the greater of 4% or .7% above the 3 month LIBOR. When the central banks cease keeping short rates artificially low, and short rates start to reflect the inflation rate again, the short LIBOR rates will start to rise.

If inflation becomes a problem down the road, the LIBOR float will eventually replace the 4% guarantee, and this will start to occur when the 3 month LIBOR rate rises above 3.3% during the applicable computation period. Historically, a 3 month LIBOR of 5% is not unusual: LIBOR Rates History (Historical) At a 5% LIBOR at the relevant computation date for this security, the coupon rate for MSPRA would rise to 5.75% or a 9.076% yield at a total cost of $15.7. The percentage yield would be about 13.85% at a 8% 3 month LIBOR. So the LIBOR floats provides some protection against rising rates. If the price of MSPRA falls from $15.7, the value of the guarantee and the float to a new purchaser will rise compared to my purchase. I will add the other 50 shares if there is another point or two decline, assuming no new, material adverse news relating to MS.

This is a link to the prospectus: www.sec.gov The dividend stopper provision is typical (see page S-14). As long as MS pays a dividend on a junior security, meaning its common stock, it has to pay the preferred stock dividend with certain limited exceptions. Once MS eliminates the cash stock dividend, however, the owner of MSPRA could legally have their dividend eliminated which may or may not happen. Several companies eliminated their common dividends and continued to pay preferred stock dividends during the Near Depression period. I just characterize the elimination of a common stock dividend as placing the traditional preferred stock owner in an enhanced danger of losing their dividend.

While some preferred stocks have cumulative dividends, mostly REITs, MSPRA and most of the equity preferred floaters are non-cumulative, which means the dividend can be eliminated just like the common stock dividend with no obligation to pay it in the future. Once the firm starts paying the common dividend in this hypothetical situation, it has to resume paying the traditional non-cumulative dividend again too. To drive this point home, I will simply quote some language from the MSPRA prospectus:

"Dividends on the Series A Preferred Stock will  not be cumulative. If our Board of Directors (or                               a duly authorized committee of the Board) has not declared a dividend before the dividend payment                               date for any dividend period, we will have no  obligation to pay dividends accrued for such                               dividend period after the dividend payment date  for that dividend period, whether or not                               dividends on the Series A Preferred Stock are declared for any future dividend period."

The QuantumOnline.com site gives the credit rating as investment grade, with Moody's at Baa1 and S & P at BBB. I did not attempt to confirm that information.

3. Bought 50 of the TC KTX at its Par Value of $25 (See Disclaimer): This buy was primarily to diversify my bond portfolio further and to further increase the cash flow into the main taxable account for later reinvestment. KTX has a 8% coupon so that is close to my current yield. This trust certificate contains a Trust Preferred originating from Xerox Capital Trust I and guaranteed by XRX as provided in the prospectus. A TP is technically a preferred stock issued by a Delaware Trust (hence the name Trust Preferred) that represents a beneficial interest in the asset of the Trust. For KTX the underlying TP contains a junior bond issued by Xerox. This security has a somewhat daunting legal structure. KTX is a Trust Certificate representing a beneficial interest in the asset of a Grantor Trust, which is a Trust Preferred stock issued by Xerox Capital Trust, and the TP represents a beneficial interest in the asset of that trust which is a junior bond issue from Xerox. In effect KTX is a junior bond from Xerox.

The underlying bond and the TC mature on the same day, which is 2/1/2027. Interest payments are made semi-annually on 2/1 and 8/1. The last ex date was on 1/27/2010: CorTS Trust For Xerox Capital Trust I, KTX The underlying bond is rated investment grade by Moody's at Baa3 and junk by S & P. Fitch has it at BBB- according to Finra. This TC was trading at about the same current yield and YTM as the underlying bond, which also has a 8% coupon. So, today, there was no advantage to buying the TC except that I no trouble buying 50 shares of the TC when I saw the spread narrow and this kind of small order is far more difficult in the bond market which trades in $1000 increments. FINRA An order for 1 bond can be made but would be frequently ignored in my experience.

The underlying bond is a typical trust preferred which means deferral of the distribution is possible for up to five years, but the distributions are cumulative. Since Xerox is currently paying a common stock dividend, I do not have to worry now about a deferral. The stopper provision reads in part as follows: "During any such period (i.e. deferral period), Xerox Corporation will not be permitted to make a payment on its capital stock or any debt securities that rank equal to or junior to the Junior Subordinated Debentures".

This is a link to the prospectus: www.sec.gov The underlying security is callable now, but Xerox would have to pay a premium as set forth at page S-13.

I placed some other trades, including a purchase of a double short near the close that had declined about 5% or so in value today. I may discuss them in my next post over the weekend or in the Monday post.

4. Interview with Louis Yamada on CNBC Friday: She recommends to "wait and see". Enough technical damage has been done to the market that "we want to see whether a repair can take place". She talks about the market hitting higher highs and higher lows since March 2009. If the DJIA falls below the low in February of around 9800, then the market could fall further.