August 22, 2008

An Assiduous Reader sent me an article from Barrons today The Endgame Nears for Fannie and Freddie:

Should the agencies fail to raise fresh capital, the administration is likely to mount its own recapitalization, with Treasury infusing taxpayer money into the enterprises, according to our source. The infusion would take the form of a preferred stock with such seniority, dividend preference and convertibility rights that Fannie’s and Freddie’s existing common shares effectively would be wiped out, and their preferred shares left bereft of dividends. Then again, the administration might show minimal kindness to preferred shareholders; local and regional bankers have been lobbying the Bushies not to wipe out the preferred since the bankers own a lot of that paper and rely on the bank preferred-stock market for much of their own equity capital.

This is similar to the scary-scenario-base-case I outlined yesterday … but the airy assertion that the result would be “preferred shares left bereft of dividends” is more than just a little vague. Left bereft for how long? That’s the key.

As with all investing, it’s important to look behind the headlines and put actual numbers together … to date, I’ve seen no actual analysis that goes beyond “The sky is falling!”.

As an illustration – a very rough one! – of what I mean, let’s work out the value of FNMPRG under the scenario above – and let’s say that the dividend is halted for five years. Given the uncertainty in the market, we’ll say we want a yield of 10%.

FNMPRG pays a dividend of $2.29 annually; we’ll assume that this is in one payment, due exactly one year from now. At ten percent, this would imply a value of $22.90 for these prefs, before accounting for five years of missed dividends.

The five years of missed dividends, discounted at 10%, have a present value of $8.44. Subtracting this from the $22.90 that the perpetual annuity is worth, we arrive at a fair value of $14.46 for the prefs, compared to their market value of $9.76. Under this scenario, the prefs are a bargain.

This, at least, represents an attempt to put numbers on the table. Is the scenario too harsh? Too lax? Change it. Put some percentage chances on it and stick it in a pot with all your other scenarios, come up with a range of values and – if it turns out to be an attractive speculation – put a little bit of money into it, with all the other little bets in your portfolio. And, if you’ve done your homework properly, and you have kept all your bets sufficiently small that a run of bad luck or bad analysis won’t hurt you – you’ll do fine.

Naturally, if you do your homework and decide that …

  • Dividends will be stopped immediately, probability 100%
  • There will be no recovery, ever, probability 100%

… then your analysis will result in a fair value estimate of the prefs of $0 and you will consider them expensive. But at least you will have done your homework and put your assumptions and scenarios on the table where you can look at them.

You can let the yumps who cry Oh, the dividend might be stopped and everything is worthless boo-hoo-hoo run along home to play with their dollies.

Amidst all this, I will stress again that I am not taking a view, one way or another, on the investment merits of the GSE prefs. I haven’t done my homework. All I’ve done is try to find an actual reference to actual analysis in the press reports and been disappointed.

Accrued Interest has passed on some GSE speculation from Merrill.

Moody’s downgraded Fannie’s prefs today:

The preferred stock ratings and BFSRs remain on review for possible further downgrade. Fannie Mae’s and Freddie Mac’s Aaa senior long-term debt and Prime-1 short-term debt ratings were affirmed with stable outlooks. The firms’ Aa2 subordinated debt ratings were affirmed, but the outlook was changed to negative from stable.

Moody’s believes these firms currently have limited access to common and preferred equity capital at economically attractive terms.

The downgrade and continued review for further downgrade of the preferred stock ratings reflects a greater risk of dividend omission on the preferred stock.

Should a capital injection result in the subordination of the existing preferred stock, or should it result in any missed preferred dividends, then the preferred stock rating would be lowered further.

I will point out that the Moody’s downgrade still leaves the prefs at investment grade, although not by much; I will further point out that the rating is an opinion on the probability of the prefs not deferring any dividends at all – in which case, the yield will be about 25%, not the 10% net that I demanded in my scenario.

All this is reminiscent of my musings on the proper analysis of FTU.PR.A; there is some doubt as to whether this will be able to pay all its dividends and 100% of principal, so its credit rating has suffered; but it’s so cheap right now that that particular scenario results in a phenomenal return. Formally, the asset coverage is only about 1.2:1, as of August 15 according to the company – but that asset coverage figure is based on the par value of $10 and the unit value of $12. Based on the current market price of the preferreds of about $7.50, asset coverage is 1.6:1 of the amount invested, a much nicer number! Even if the underlying US Financials do terribly over the next few years and the prefs eventually recover only the current price of $7.50 (which counts as a default), interim dividends (if actually received, of course) of $0.525 p.a. will have resulted in a yield of 7%, which some might consider to be rather good. There are other scenarios, which result in returns being “extremely good” … and yet other scenarios, which result in returns ranging from “lousy” to “disastrous”. Do yer homework, gents, and place yer bets! Small ones!

Oh! And I like to keep abreast of the Thornburg Mortgage situation, since that’s been the most spectacular flame-out so far into the current crunch or preferreds in North America. Investing Thoughts brings to my attention a press release on the story so far:

As of 5:00 p.m., New York City time, on August 19, 2008, holders of Preferred Stock had tendered approximately (i) 88.7% (5,786,035 shares) of the Series C Preferred Stock; (ii) 83.5% (3,340,873 shares) of the Series D Preferred Stock; (iii) 91.7% (2,900,546 shares) of the Series E Preferred Stock and (iv) 96.2% (29,161,031 shares) of the Series F Preferred Stock.

Shareholders who participate in the Exchange Offer will receive $5.00 in cash and 3.5 shares of the company’s common stock for each share of Preferred Stock validly tendered and accepted. Holders of the Preferred Stock who have previously tendered their shares of Preferred Stock continue to have the right to revoke such tenders at any time prior to the new expiration date by complying with the revocation procedures set forth in the Offering Circular relating to the Exchange Offer.

Total book value of all series of Thornburg’s preferreds was around $832-million as of Dec. 31/07.

I suppose that every now and then I should mention something about the Canadian preferred market, seeing as that’s what this blog is supposed to be about … although the market has rationalized itself somewhat over the past month, there’s still plenty of craziness left. For instance, good old BAM.PR.O, which had a very poorly received underwriting in June and performed poorly in the last half of July. Credit concerns, possibly? Well, riddle me this: Why does it yield more than the perps? It is bid at 22.90 to yield 7.33% until optionCertainty 2013-6-30, while the perpetuals BAM.PR.M and BAM.PR.N are both bid at 16.90 to yield 7.17%.

An extremely quiet day on the preferred share market today, but PerpetualDiscounts did creep up and have almost repaired July’s damage.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet N/A N/A N/A N/A 0 N/A N/A
Fixed-Floater 4.62% 4.38% 56,112 16.42 7 +0.0524% 1,108.6
Floater 4.04% 4.08% 44,187 17.19 3 -0.2417% 913.0
Op. Retract 4.96% 4.23% 109,641 2.54 17 +0.1153% 1,050.1
Split-Share 5.36% 5.98% 54,760 4.37 14 -0.2364% 1,038.2
Interest Bearing 6.23% 6.69% 46,702 5.23 2 +0.3071% 1,124.0
Perpetual-Premium 6.17% 6.09% 64,676 2.23 1 -0.2362% 991.2
Perpetual-Discount 6.07% 6.12% 190,656 13.54 70 +0.0937% 877.2
Major Price Changes
Issue Index Change Notes
FBS.PR.B SplitShare -1.9388% Asset coverage of just under 1.5:1 as of August 21, according to the company. Now with a pre-tax bid-YTW of 6.41% based on a bid of 9.61 and a hardMaturity 2011-12-15 at 10.00.
MFC.PR.B PerpetualDiscount -1.2573% Now with a pre-tax bid-YTW of 5.70% based on a bid of 20.42 and a limitMaturity.
ELF.PR.G PerpetualDiscount -1.2493% Now with a pre-tax bid-YTW of 6.94% based on a bid of 17.39 and a limitMaturity.
WFS.PR.A SplitShare -1.1579% Asset coverage of 1.6+:1 as of August 14, according to Mulvihill. Now with a pre-tax bid-YTW of 8.05% based on a bid of 9.39 and a hardMaturity 2011-6-30 at 10.00.
POW.PR.D PerpetualDiscount +1.0319% Now with a pre-tax bid-YTW of 6.17% based on a bid of 20.56 and a limitMaturity.
BNS.PR.L PerpetualDiscount +1.0433% Now with a pre-tax bid-YTW of 5.88% based on a bid of 19.37 and a limitMaturity.
BAM.PR.I OpRet +1.1979% Now with a pre-tax bid-YTW of 6.16% based on a bid of 24.50 and a softMaturity 2013-12-30 at 25.00. Compare with BAM.PR.H (6.05% to 2012-3-30), BAM.PR.J (6.39% to 2018-3-30) and BAM.PR.O (7.33% to 2013-6-30).
BNS.PR.M PerpetualDiscount +1.3082% Now with a pre-tax bid-YTW of 5.88% based on a bid of 19.36 and a limitMaturity.
NA.PR.L PerpetualDiscount +1.5416% Now with a pre-tax bid-YTW of 6.19% based on a bid of 19.76 and a limitMaturity.
HSB.PR.D PerpetualDiscount +1.5686% Now with a pre-tax bid-YTW of 6.14% based on a bid of 20.72 and a limitMaturity.
GWO.PR.H PerpetualDiscount +1.8786% Now with a pre-tax bid-YTW of 5.83% based on a bid of 21.15 and a limitMaturity.
MFC.PR.C PerpetualDiscount +2.0090% Now with a pre-tax bid-YTW of 5.55% based on a bid of 20.31 and a limitMaturity.
Volume Highlights
Issue Index Volume Notes
BAM.PR.O OpRet 38,187 See above
NA.PR.L PerpetualDiscount 17,900 Anonymous bought 10,000 from Penson at 19.60. Now with a pre-tax bid-YTW of 6.19% based on a bid of 19.76 and a limitMaturity.
BNS.PR.L PerpetualDiscount 13,580 Now with a pre-tax bid-YTW of 5.88% based on a bid of 19.37 and a limitMaturity.
BNS.PR.M PerpetualDiscount 12,750 Now with a pre-tax bid-YTW of 5.88% based on a bid of 19.36 and a limitMaturity.
RY.PR.D PerpetualDiscount 12,000 Now with a pre-tax bid-YTW of 6.11% based on a bid of 18.54 and a limitMaturity.

There were four other index-included $25-pv-equivalent issues trading over 10,000 shares today.

4 Responses to “August 22, 2008”

  1. prefwatcher says:

    I would guess that the discrepency in the pricing and yields between and and n has to do with the potential for capital gains. The m&n prefs traded as high as $25 in 2007…the closing price on 22/8/08 was $16.90.If rates fall (and the BAM credit rating doesn’t deteriorate) it is possible the m&n prefs could go back to par which would give rise to a substantial gain. The O prefs are unlikely to gain as much under this scenario because of the 2013-6-30 option certainty at $25.00.

  2. jiHymas says:

    That is indeed a possibility, but if one were to be buying PerpetualDiscounts as a speculation on rates, it seems to me that the higher quality stuff – RY, for instance – would be a better bet.

    We’re not seeing this kind of inversion with MFC, or with OpRet & SplitShare issues in general – only with the BAM. Note also that BAM.PR.O is not just oddly priced relative to the perpetuals, but is also out of whack against other BAM retractibles.

    I suspect that this is simply a lingering hangover from a poorly received underwriting, but holy smokes, is it ever mispriced against other issues from the same issuer!

    I’m not saying you’re wrong, mind you … rationalizing market prices is always a tricky thing!

    You know, I saw your handle as a commenter on this post and thought I was going to be taken to task for not loathing the FNM prefs again!

  3. […] been puzzled for some time as to why BAM Perps yield less than BAM retractibles (discussed on August 22) … the duration hypothesis from Assiduous Reader prefwatcher didn’t convince me at the […]

  4. […] to it frequently in conversation over the past six months – it was last mentioned on PrefBlog on August 22. It is the only example I know of in which preferred shareholders were the target of a partial […]

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