It’s interesting:
1. Preferred Shares and GICs (1)
2. Perpetual and Retractible Preferred Shares (2)
3. Why Invest in Preferred Shares? (3)
4. Corporate Bonds … or Preferred Shares? (5)
5. Trading Preferreds (6)
6. A Brief Introduction to Preferred Shares (4)
7. Interest Bearing Preferreds (7)
8. Modified Duration (8)
9. The Bond Portfolio Jigsaw Puzzle (10)
10. Dividends and Ex-Dates (-)
The bracketted numbers give the positions on the January Top 10 List – there’s not much change!
Royal Bank of Scotland is considering a liability management exercise that could see it buy back or convert part of a 14 billion pound pile of preference shares and innovative securities to boost its core capital.
Analysts have said the move could help part-nationalised RBS take advantage of discounted prices in the secondary market to generate a bumper equity gain and boost its core Tier 1 ratio, a key measure of capital strength.
As a simplified example of how this works, we can look at simplified bank balance sheets:
| Bank Balance Sheet Before Preferred Buy-Back |
|
| Assets | Liabilities |
| Cash $10 | Deposits $80 |
| Loans $90 | Preferreds $10 |
| Equity $10 | |
Assume the preferreds are bought back for half of face value. Then:
| Bank Balance Sheet After Preferred Buy-Back |
|
| Assets | Liabilities |
| Cash $5 | Deposits $80 |
| Loans $90 | |
| Equity $15 | |
If we further assume that the “Loans” have a Risk-Weight of 1, then:
a) The Tangible Common Equity Ratio has increased from 11% to 17%
b) The Tier 1 Ratio has declined from 22% to 17%
c) The bank has booked a profit of $5
Dominion Bond Rating Service has released a study titled Recent Regulatory Developments for Canadian Pipeline and Utility Companies:
“None of the decisions rendered in Q4 2009 are viewed by themselves as materially changing any one entity’s financial risk profile,” concludes [DBRS Managing Director] Mr. [Michael] Caranci. “Rather, the improvements are viewed as supportive of current ratings and would improve flexibility within the rating category.”
It’s interesting:
1. Preferred Shares and GICs (1)
2. Perpetual and Retractible Preferred Shares (2)
3. Why Invest in Preferred Shares? (5)
4. A Brief Introduction to Preferred Shares (6)
5. Corporate Bonds … or Preferred Shares? (3)
6. Trading Preferreds (8)
7. Interest Bearing Preferreds (4)
8. Modified Duration (9)
9. Break-Even Rate Shock (-)
10. The Bond Portfolio Jigsaw Puzzle (-)
The bracketted numbers give the positions on the December Top 10 List – there’s not much change!
DBRS has issued a press release, DBRS Clarifies its Approach to Rating Bank Subordinated Debt and Hybrid Instruments.
I love the word “clarifies”. It should mean “make clearer” or “resolve ambiguity”, but is nowadays used by smiley-boys to mean “changing our position while hoping you don’t notice”.
The interesting bits are as follows:
DBRS does not view the ability to defer payments as a credit risk, but rather, a risk that holders of the deferrable instruments have agreed to as per the contractual terms of the instrument and DBRS does not consider “deferral” as being equal to “default”.
…
Notching for Deferral or Skipping of PaymentsDBRS will add an additional notch when instruments with discretionary payments defer or skip. This notch will be applied as long as discretionary payments are not being made. This additional notch serves to differentiate between instruments that are still making payments from those that are not paying, but otherwise meeting the instrument’s terms and covenants. As noted already, DBRS does not view the exercising of the right to defer or skip payments as equivalent to default. Typically, a bank that defers or skips discretionary payments is usually in significant difficulty, so that its senior debt rating is already under pressure and its rating has likely been lowered. That results in lower ratings for subordinated debt. Recent examples, however, have illustrated occasions when a bank may defer or skip due to regulatory events, but retain significant strength and remain investment grade. In these circumstances, the senior debt rating remains the principal driver of the likelihood that payments will be resumed and insolvency avoided.
This represents something of a change from their treatment of Quebecor World:
While the cumulative nature of the Series 3 and Series 5 preferred shares affords Quebecor World the flexibility to suspend dividends, provided dividends are paid in arrears, DBRS notes preferred shareholders maintain a level of expectation that these dividends will be paid in a timely manner, and this expectation is reflected in the preferred share ratings. Having not met the expectation of preferred shareholders, DBRS notes the preferred shares are more reflective of a “D” rating.
What’s right or wrong? There is, of course, no right or wrong.
DBRS is definitely in the wrong, though, for changing their policy under the banner of “clarification” and for not specifying just what does constitute a default under their terminology. When does a Straight Perpetual default? Not when it skips a payment, under the new policy. So when? When it enters CCCA protection? When it’s written down or otherwise has its claim on assets extinguished? When?
James Hamilton of Econbrowser has republished a paper he wrote for the UCSD Economics Department’s Economics in Action, with the title What Went Wrong and How Can We Fix It?.
He makes a few assertions which I dispute:
The institutions that originally made the loans sold them off to private banks or to the government-sponsored enterprises Fannie Mae and Freddie Mac. This system created moral hazard incentives for the originators, encouraging them to fund unsound loans. When private banks bought the loans, they packaged them into complex securities that were in turn sold off to private investors, an additional step that permitted the securitizers to profit, even if the loans were poor quality.
Increased regulation of securitization is certainly a very sexy issue nowadays, and it appears that tranche retention of some kind will be mandated in the future. Why not? It’s a nice simple story, easily understood by the man in the street and makes it look as if regulators are Taking Action. But does it mean anything?
The UK’s Financial System Authority says, in its Financial Risk Outlook 2009 (previously reported on PrefBlog:
Hence, the new model of securitised credit intermediation was not solely or indeed primarily one of originate and distribute. Rather, credit intermediation passed through multiple trading books in banks, leading to a proliferation of relationships within the financial sector. This ‘acquire and arbitrage’ model resulted in the majority of incurred losses falling on banks and investment banks involved in risky maturity transformation activities, rather than investors outside the banking system. This explosion of claims within the financial system resulted in financial sector balance sheets becoming of greater consequence to the economy. Financial sector assets and liabilities in the US and the UK grew far more rapidly as a proportion of GDP than those of corporates and households (see Chart A7 and A8).
There’s a good chart … somewhere, produced by somebody … that conveys this information in visual form, but I can’t remember where I saw it!
Anyway … since that’s what happened, what good is mandated tranche retention going to do? The banks collectively believed in their collective product and held it. If it had, in fact, been forced down the throat of poor innocent pension funds because the banks considered it a hot potato, we’d have a global pension fund solvency crisis right now and we don’t – at least, not much worse than usual.
Additionally, tranche retention is simply another excuse for the lazy not to do any work. Seems to me that if you’re buying a billion dollars worth of mortgages, maybe you should have a look at what you’re buying, regardless of whether the seller holds a 5% tranche or not. But perhaps I’m just old-fashioned that way.
I also feel Dr. Hamilton’s statement regarding AIG is imprecise, while not being incorrect:
Entities like the insurance giant AIG were allowed to write huge volumes of credit default swaps that purportedly would insure the holders of these mortgages against losses, even though AIG did not remotely have the financial ability to fulfill all the commitments it made
The issue is not that AIG wrote so much protection, but that regulators allowed banks that held it to offset risky positions without collateralization (in fact, the only financial institution with enough brains to demand collateralization, Goldman Sachs, is regularly vilified for doing so in the gutter blogs).
Regardless of one’s views on whether a central clearing house for derivatives is a good idea (I don’t think it is), it should be apparent that the driving force behind the idea is a regulatory smokescreen. Fully collateralized, so what? The regulators could have demanded full collateralization a long, long time ago – and should have: any uncollateralized exposure should have soaked up the exposed bank’s capital – but they didn’t.
I think he misses a point about Fannie and Freddie:
In the cases of Fannie and Freddie, the government created an asymmetric payoff structure in which the profits went to private investors while the losses were picked up by the taxpayers.
True enough, but that’s not the whole problem; perhaps not even the real problem. Fannie & Freddie depressed mortgage rates due to their implicit government guarantee. When Agency paper trades right on top of Treasury’s, what profit is left for private enterprise? It’s fairly well accepted at this point that one reason why Canadian banks have been so resilient is because they can earn economically satisfactory returns by holding residential mortgages (see IMF Commentary and OSFI commentary, as well as commentary on Australian banks) – they didn’t need to reach for yield.
A Bloomberg story just appeared Moody’s May Downgrade Up to $450 Billion of Bank Debt:
Moody’s Investors Service is reviewing about $450 billion of bank hybrid and subordinated notes for possible downgrade after changing the assumptions underlying its ratings of the debt.
Some 775 securities issued by 170 “bank families” in 36 countries are affected, the New York-based risk assessor said in an e-mailed statement. Half the hybrids may have their ratings lowered by three to four grades, 40 percent may be cut by one or two grades and the remainder may be lowered by five steps or more, it said.
…
Moody’s reviews come after it stopped assuming holders of hybrids, which mingle characteristics of debt and equity, would benefit from government support for troubled lenders after the global financial crisis proved that wasn’t the case. The new system expects regulators to treat them more like equity, and takes into account the risk that banks might be forced to suspend coupon payments on their lower-ranked debt.
There does not appear to be a press release or notice on the Moody’s website yet … all I found was a July 28 press release saying that they expected to finalized the methodology in September, which was part of the same story reported on PrefBlog in June.
But then I had a look at their ratings list for Bank of Montreal and hey, looky-looky! All the prefs have “Possible Downgrade, 18 NOV 2009” under “Watch Status”. It the same thing for BNS, by the way, so the notation is not related to the extant Moody’s Watch on BMO.
Stay tuned.
CIT Group has announced:
that, with the overwhelming support of its debtholders, the Board of Directors voted to proceed with the prepackaged plan of reorganization for CIT Group Inc. and a subsidiary that will restructure the Company’s debt and streamline its capital structure.
Importantly, none of CIT’s operating subsidiaries, including CIT Bank, a Utah state bank, will be included in the filings. As a result, all operating entities are expected to continue normal operations during the pendency of the cases.
All classes voted to accept the prepackaged plan and all were substantially in excess of the required thresholds for a successful vote. Approximately 85% of the Company’s eligible debt participated in the solicitation, and nearly 90% of those participating supported the prepackaged plan of reorganization.
Similarly, approximately 90% of the number of debtholders voting, both large and small, cast affirmative votes for the prepackaged plan. The conditions for consummating the exchange offers were not met.
Accordingly, CIT’s Board of Directors approved the Company to proceed with the voluntary filings for CIT Group Inc. and CIT Group Funding Company of Delaware LLC with the U.S. Bankruptcy Court for the Southern District of New York (“the Court”).
Due to the overwhelming and broad support from its debtholders, the Company is asking the Court for a quick confirmation of the approved prepackaged plan. Under the plan, CIT expects to reduce total debt by approximately $10 billion, significantly reduce its liquidity needs over the next three years, enhance its capital ratios and accelerate its return to profitability.
Note that the Maple issue, 4.72% Notes due February 10, 2011, are in Class 9, the largest class of notes with about $25-billion outstanding. According to the proxy solicitation:
Estimated Recovery: 94.4%, assuming (i) acceptance of the Plan of Reorganization by Class 7 Canadian Senior Unsecured Note Claims, Class 12 Senior Subordinated Note Claims and Class 13 Junior Subordinated Note Claims and (ii) New Common Interests valued at mid-point of Common Equity Value (as defined herein) range.
CIT’s $500 million of notes due Nov. 3 fell to 68 cents on the dollar as of Oct. 29 from 80 cents at the beginning of the month, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
According to the DTCC Warehouse, there are $54-billion gross and $3-billion net single name CDS outstanding on CIT, with 6,638 contracts.
In a comment on the post about HM Treasury’s musings on mandatorially convertible prefs, Assiduous Reader patc provided an introduction to what seems to be the wonderful world of Australian Hybrids.
Further investigation uncovered a Morningstar / “Huntleys’ Your Money Weekly” analytical report titled ASX Listed Hybrids:
These securities pay a regular distribution or dividend. The calculation for most instruments is similar. Start with the 90 or 180 Day Bank Bill Swap Rate (see graph below), which is the rate at which major financial institutions commonly lend money to each other. This rate often sits a little bit above the Reserve Bank cash rate, so now for instance the 90 day rate is sitting at 3.25%, above the cash rate at 3%. To this you add a margin, which differs from security to security. For instance the ANZ offering, with ASX Code ANZPB, has a margin of 2.5%, CBAPB has a margin of 1.05%, WBCPB has a margin of 3.8%.
…
The distribution may be franked and the numbers we quote include the franking credit where applicable.
…
Many bank hybrids have Mandatory Converting Conditions. There are offerings of this variety from Westpac, ANZ and CBA, as well as Macquarie and Suncorp. At the end of the term, around the Mandatory Conversion Date there are tests against the share price of the underlying security. For instance ANZPB is tested against the share price of ANZ. If the volume weighted average share price (VWAP) of the institution is above some threshold just prior to the Mandatory Conversion Date then the issuer must convert the hybrid securities into a variable number of ordinary shares – the value of the shares will be the face value of the hybrid plus a small conversion discount, typically 1%–2.5%. Often there’s a test that the price on the 25th business day before the mandatory conversion date is at least above 55–60% of the issue date VWAP, and then that the VWAP for the 20 business days prior to the conversion date is above 50–52% of the issue date VWAP.
Note that I have no idea what “franking” means!
The potential for a significant market in this asset class in Canada was discussed when the market was just about at its bottom in December 2008 in the post Convertible Preferreds? In Canada?.
Sadly, these preferreds approach mandatory conversion from the wrong direction: mandatory conversion occurs when the price of the common is above some level, rather than below, which – from the point of view of market stability – is undesirable. Ideally, the fixed charges inherent in debt-like instruments will be eliminated when the company’s in trouble – by conversion to common – but in this case the implication is that the fixed charges will remain in such a case, and be eliminated if the company does well (or, at least, treads water).
Note that these Australian instruments bear a distinct resemblance to Canadian OperatingRetractibles, the major differences being: