PrefBlog

ROC Pref Corp. III has released the Management Information Circular for the meeting regarding its potential dissolution. It includes some cheery statements:

The Credit Linked Note has been structured so that it is unaffected by the first net losses on the CLN Portfolio up to 3.84% of the initial value of the CLN Portfolio (representing defaults by eight Reference Companies in a CLN Portfolio comprised of 125 Reference Companies). The net loss on a Reference Company that defaults is calculated as the percentage exposure in the CLN Portfolio to such Reference Company multiplied by 60.0% (based on a 40.0% fixed recovery rate).

Since the Credit Linked Note was issued there have been 8.5 defaults in the CLN Portfolio. These companies include Dana Corporation, Fannie Mae, Freddie Mac, Lehman Brothers Holdings Inc., Washington Mutual, Tribune Company, Idearc Inc., Lear Corporation and CIT Group Inc. Idearc Inc. was a spin-off from Verizon Communications Inc. and therefore was represented in the CLN Portfolio at a one-half weight and constituted a half default.

The fixed recovery rate sounded like a good idea at the time – and, I understand, was preferred by the ratings agencies – but hurt a lot with Fannie and Freddie. CIT Group recovery, too, will be well in excess of the benchmark.

But to my mind, the most interesting part is:

The issuer of the Credit Linked Note, TD Bank, has agreed to repurchase the Credit Linked Note prior to maturity at a price equal to the value of the Credit Linked Note on December 18, 2009 plus an amount equal to $1.00 multiplied by the number of Preferred Shares then outstanding. The price at which TD Bank is obligated pursuant to a note repurchase agreement to repurchase portions of the Credit Linked Note in the event that Shareholders exercise their monthly retraction rights represents a discount to the value of the Credit Linked Note. There is no assurance that the agreement with TD Bank to repurchase the Credit Linked Note at the more favourable price would be available in the future.

Later on, they note that the Method of Valuation is described in the Annual Information Form, incorporated by reference. Oddly, Connor Clark & Lunn’s website publishes the 2008 AIF, but the 2009 AIF is available only on SEDAR. The 2008 version states:

The CLN is valued on the 10th and last business day of each month by TD Bank. Factors affecting the value of the CLN include the market‘s assessment of overall credit quality of the Reference Portfolio, as measured by the trading price of the debt (and derivatives thereof) of companies in the portfolio, and interest rates as measured by the Canadian dollar swap rate to the date of maturity of the note, as well as the value of the trading reserve account. At June 30, 2008, the CLN value was $102.6 million, down from $219.6 million at June 30, 2007.

The 2009 version states:

The CLN is valued on the 10th and last business day of each month by TD Bank. Factors affecting the value of the CLN include the market’s assessment of overall credit quality of the Reference Portfolio, as measured by the trading price of the debt (and derivatives thereof) of companies in the portfolio, and interest rates as measured by the Canadian dollar swap rate to the date of maturity of the note, as well as the value of the trading reserve account. At June 30, 2009, the CLN value was $40.9 million, down from $102.6 million at June 30, 2008.

All in all, I don’t get it. Why is TD Bank willing to pay $1 more than NAV? This question is not addressed in the supplied FAQs.

My best guess at an answer is that it has to do with the power of substitution – the following is taken from the 2009 AIF:

The CLN features an embedded trading reserve account (the “Trading Reserve Account”), initially in an amount of $2.1 million, which stood at $nil million on June 30, 2009. The Trading Reserve Account may be available to absorb net losses that might be incurred when making substitutions in the Reference Portfolio. The Trading Reserve Account was used to purchase additional subordination from TD Bank following the November restructuring initiatives.
…
The Reference Portfolio is managed by the Investment Manager. The Investment Manager’s goal is to reduce the likelihood of having exposure to companies that default on their senior obligations. To that end, the Investment Manager can add or remove companies through a substitution process executed in accordance with the terms of the CLN. If the Investment Manager decides to remove a company that, in its judgment, has increased in risk, and to replace it with a lower risk company, there may be a net cost to the Trading Reserve Account depending on the credit spread comparison between the companies being substituted. The Trading Reserve Account described above may be available to absorb net losses that may be incurred through these substitutions.

The Investment Manager has made 66 substitutions in the Reference Portfolio since inception at a net benefit of $2.5 million to the Trading Reserve Account which, was used in the restructuring of the CLN.

It may be that the value – however it’s calculated – of the note is $3.50 per preferred, but with an infusion of – say – $2.00 new capital, substitutions could be effected to bring it to $10.00. Under this scenario, the ROC Pref III Corp. is scuppered because it has run out of money and has no reasonable way of getting more (and therefore cannot effect substitutions; also, even if they could get some money, they might not be permitted to put it into the CLN), but TD will be very happy to pay $3.50 NAV + $1.00 Premium + $2.00 recapitalization to get a $10.00 value.

I will make haste to note, however, that the above paragraph represents uninformed speculation on my part; I have always loathed structured products (whenever you want to sell, there’s exactly one buyer, at the ready with a large vise); I have no experience in the valuation of this sort of note; and acquiring such expertise would take me considerable time. Trying to understand preferred shares and more normal fixed income instruments is more my style.

Still … if I held RPB.PR.A, I’d be asking Connor Clark: “Before I vote, please tell me why TD is paying $1 over NAV.” They will almost certainly blandly direct inquiries of this nature to TD, so the follow-up question is: “Why aren’t you effecting substitutions out of the riskier elements of the portfolio?”

RPB.PR.A was last mentioned on PrefBlog when they announced their intention to hold the vote. RPB.PR.A is not tracked by HIMIPref™.

Update: The 2009 Annual Information Form is now available via CCL group.

This entry was posted on Friday, December 4th, 2009 at 1:53 pm and is filed under Issue Comments. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.