Category: Miscellaneous News

The Financial Post has published a piece on Canadian bank preferreds: PIMCO questions Canada’s love for bank preferreds:

“I’m not buying them,” Mr. Devlin said in an interview. The problem with preferred shares is that investors are ignoring significant risks that could show up down the road, he said.

Mr. Devlin said Canada is one of a handful of countries where investors are willing to pay such a high price for bank preferred shares.

“That’s the most subordinated debt you can get, that’s the stuff that’s been destroyed [by the financial crisis],” he said. “Tier 1 capital around the world is trading anywhere from 25¢ on the dollar to 50¢ on the dollar. In Canada it’s trading at [a premium],” he said. “Its astonishing, it’s just eye popping.”

An interesting point of view, but not backed up in the article. I will point out that premia and discounts are meaningless. A bond with a coupon in excess of its yield will trade at a premium. A bond with a coupon less than its yield will trade at a discount. So?

I’m sure he said many other things, but the critical question is the yield spread between Tier 1 capital and the Senior debt, and whether that spread is too wide or too narrow. As written, the article is just another “I know the world will probably still exist next week but what if it doesn’t” scare story.

In an essay posted on PIMCO’s website urging BoC purchases of government debt, Mr. Devlin noted:

The good news is that the BoC has time. Canada does not have a major financial institution looking for a significant equity injection at this point. The Insured Mortgage Purchase Plan (IMPP) has worked spectacularly well in re-liquifying bank balance sheets. Canada remains one of only two countries in the developed world where the market is still open for banks to raise tier 1 capital, so Canadian banks have not needed to use the government debt guarantee program.

Many thanks to Assiduous Reader MM for bringing this to my attention!

Barry Critchley of the Financial Post has been all over the map on Fixed-Resets:

• He adored the initial issues
• then he sounded a cautionary note
• he recently published an effusive column

… and now he is warning that “redeemable” is different from “retractible”:

If the prefs are not redeemed, in five years holders will be offered a choice of a new fixed-rate pref or an option to convert to a floating-rate pref. The rate will be set at the same spread as the original fixed-rate prefs. (Over time, the spread has widened to 450 basis points from 160 basis points.) The actual rate offered could be lower or higher than the original coupon.
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Now, Len Ruggins, a former senior financing executive with BCE, has weighed in. He argues the terms are “greatly tilted in the issuer’s favour, primarily because of their option to periodically call the issue at their pleasure.”
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Ruggins said he “would buy into these issues if they were non-call for financial advantage for at least 25 years. This, in my mind, would establish a level playing field between the issuer and the investor. I am not trying to cut off a source of capital for our Canadian banks. However, I don’t think they should take undue advantage of the financially unsophisticated retail investor.”

By and large, Mr. Critchley’s attitude towards the structure has become more cautionary as the terms of new issues have improved! I consider the recent spate of new issues to be somewhat rich compared to PerpetualDiscounts, but to a much smaller degree than they were a year ago. In fact, there is now enough overlap between the more expensive PerpetualDiscounts and the cheaper FixedResets that the fund I manage has taken some opportunistic positions in Fixed Resets, as disclosed in the portfolio composition review for January 2009.

It is interesting to compare this column with the column by Rob Carrick of the Globe and Mail, published on the same day.

Update, 2009-3-31: In light of the comments to this post by Assiduous Reader GAndreone, I thought it would be interesting to post the HIMIPref™ Option Calculation Box for BMO.PR.O as of 2009-3-30. Note that I do not claim that this represents a perfect and correct calculation of what the price of the option would be if it was separable from the preferred share; I will say, however, that the various parameters used as inputs … er … how shall I phrase this … seem to work pretty much OK when used as part of HIMIPref™’s valuation routine.

Update, 2009-3-31: There’s a great comment on the G&M story:

Bruce King from Canada writes: I think James Hymas is stuck with a lot of straight preferreds that have tanked and he’s hoping to drum up some demand in order to unload them on us. He’s probably salivating at the chance to generate enough cash to buy some of the new rate-reset preferreds.

Curses! Foiled!

Barry Critchley used his column in the Financial Post to note Rate-Reset Prefs Gain Followers:

In all, $8.7-billion of Tier 1 capital has been raised (about half of that this year) and those fundings have helped the Canadian banks overcome any capital problems that may have arisen because of the global financial crisis and the recession.
…
So why have they been so successful? “The investment community like the structure because in five years time you have the option of redemption or going floating or fixed. The five-year horizon is much more attractive from managing interest-rate risk perspective,” said Nagel.

Attractive, sure. The reset feature is worth something, I’ve always agreed with that part. Historically, however, purchasers have paid too much (that is, accepted a small yield and given the issuers generous redemption terms) for the benefit – but the situation is improving; fixed-resets have recently been seen in the Malachite Aggressive Preferred Fund portfolio on an opportunistic basis; further weakness may make the sector as a whole competitive with straights.

But we will see!

Therese M. Vaughan, 2009-3-5:

As has been well documented, large complex financial institutions with insurance operations – like AIG – have produced systemic risks within the economy. The insurance businesses in these holding companies have thus far been adequately protected by state insurance regulations.

Florida Senate, Interim Project Report 2002-204:

According to the NAIC, the “…RBC formula produces a regulatory minimum amount of capital that is tailored to each specific company.” [Mike Barth, “Ranking Insurers by RBC Results: Still Not Such A Smart Move,” NAIC Research Quarterly, April 1995, p. 46.] The RBC formula is not meant to be used as a tool to compare or rank insurers. The risk-based capital system is just one of many tools a regulator uses for evaluating the solvency of an insurer. Insurers are prohibited from advertising the results of these calculations, and the department is prohibited from using the information in rate making. The department is authorized to use the reports solely for monitoring the solvency of insurers and assessing the need for corrective action with respect to insurers.
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The annual statement submitted to the department includes some of the results of the risk-based formula, such as the authorized control level risk-based capital and a company’s total adjusted capital. The National Association of Insurance Commissioners has stated “…that public disclosure of the results of the formulas…is an appropriate means of providing consumers with valuable information about the capital adequacy of insurance companies.” [ibid]
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Key results of the risk-based capital formula are included in an insurer’s annual statement, which is a public record.

NAIC Research Quarterly and Index

Mike Barth, in NAIC Research Quarterly, 1995:

The risk-based capital requirements for insurers, as embodied in the life/health and property/casualty formulas, as well as the Risk-Based Capital for Insurers Model Act, were developed by the NAIC to distinguish adequately capitalized companies from inadequately capitalized companies. The NAIC believes that public disclosure of the results of the formulas, as indicated by the Authorized Control Level RBC and a company’s Total Adjusted Capital, is an appropriate means of providing consumers with valuable information about the capital adequacy of insurance companies.
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There is, however, no formula available that says how much capital in excess of the RBC minimums is “good,” how much is “better,” or how much is “best.”
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Table 1 presents the most compelling reason for disallowing the practice of making RBC comparisons between adequately capitalized companies. The first five companies listed on the table are among the largest life insurance companies in terms of asset size. Their RBC results from 1993 and 1994 were taken from the Five Year History page of the 1994 annual statement filing. The second set of five companies were selected for comparison for two reasons: (a) each of these companies had a higher 1993 RBC ratio than the first five companies, and (b) each of these companies had a much worse ratio in 1994. In fact, three of the companies in the second group would trigger one of the regulatory intervention levels in 1994 and the other two would trigger the trend test. Those that have advocated using RBC ratios to rank insurers, to make loan decisions, to make underwriting decisions on whether to extend reinsurance, or to make a recommendation on selecting one insurer’s products over another’s should examine these results closely and then ask themselves if the use of RBC ratios for those purposes is really such a smart decision.

NAIC Annual Filings

From the ING Canada 4Q08 Press Release:

Preferred shares and debt securities were not impaired. Preferred shares are generally only impaired if the issuer is significantly downgraded, stops paying dividends, or declares bankruptcy. After careful review, management determined that there was no objective evidence at the time of assessment which suggested the company would not receive the contractual cash flows from these securities, which include either dividends or interest payments. Management uses third party credit ratings as well as other public information in its analysis of the quality of debt securities and preferred shares.

According to page 13 of the report, their unrealized loss on Prefs was $522.5-million. Thats on a book value (page 30) of $1,220.1. And you thought YOU had a bad year! They include prefs with equity, by the way.

Page 23 states:

ING Canada Inc.’s long-term issuer rating with Moody’s Investors Services is A3 and the company’s five principal operating insurance subsidiaries are rated Aa3 for insurance financial strength (IFS). ING Canada Inc.’s unsecured debt would be rated A (low) by DBRS. ING Canada Group has an A+ (Superior) rating from A.M. Best.

Let’s have a little peek at the balance sheet … shareholders’ equity as stated is $2,632.6-million, less intangibles of $217.8 leaves $2,414.8-million.

Debt securities of $3,832.5-million implies leverage there of 159%. Equities of $2,015.1 implies leverage of 83% … and most of that is prefs.

The company is now independent of ING Groep. We want a pref issue!

Update: I’m not sure how enthusiastic I am about the insurers owning a lot of each other’s (OK, and maybe the banks’) preferred shares. To me, that increases the chance of systemic collapse.

Update, 2010-7-28: Note that ING Canada is now Intact Insurance. Now that I have the word “Intact” in this post, perhaps I’ll be able to find it in less than half an hour next time!

OK, OK, I know that this is a blog about preferred shares … but I can’t resist sneaking in the occasional story about Credit Default Swaps.

In the primer on CDS I referred to a paper by Hu & Black regarding debt decoupling:

We have also heard from bankruptcy judges that they sometimes see odd behavior in their courtrooms, which empty crediting might explain. For example, one judge described a case in which a junior creditor complained that the firm’s value was too high, even though a lower value would hurt the class of debt the creditor ostensibly held.

Now we’ve got a reasonably big name company going to the mat in US courts at … well, not quite the peak of hysteria, but pretty close … to “recouple” the interests of the cash and derivative markets … as reported by the Financial Times:

Lawyers for Lyondell Chemical, the US unit that is in Chapter 11, have secured a temporary restraining order and preliminary injunction against a group of creditors.
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“The threat of CDS holders trying to force companies into an insolvency in order to trigger their recovery rights against their CDS counterparty will almost certainly be an issue in the wave of debt restructurings this year,” said Mark Hyde, head of debt restructuring at Clifford Chance, an adviser to LyondellBasell in Europe. Mr Hyde said that in cases where investors attempted such actions, it could undermine chances of completing a successful restructuring. Mr Hyde declined to comment on the specifics of the Lyondell case.

LyondellBasell could become an important test case for CDS markets and the restructuring industry.

There have already been a number of cases where CDS investors have been able to exert a strong influence on either the financing or restructuring of companies. These include VNU, the multinational media business, GUS, the UK retail group, and Cablecom, a Dutch communications company.

However, there have not yet been reported examples of CDS investors forcing a company into insolvency simply to trigger protection payments from the contracts they have bought.

This is fascinating. Watch this space … and make some popcorn.

Catapult Financial, a wholly owned subsidiary of Aston Hill has announced that:

Preferred Share Investment Trust (the “Trust”) announces that it has filed a preliminary prospectus with the securities regulatory authorities of all of the Canadian provinces for an initial public offering of trust units (the “Units”).

The Trust has been created to invest in an actively managed portfolio (the “Portfolio”) comprised primarily of investment grade preferred shares and to a lesser extent investment grade corporate debt and convertible bonds in order to provide Unitholders with the opportunity for growth of their investment value through any capital appreciation of the Portfolio and quarterly distributions.

The Portfolio will be actively managed by Catapult Financial Management Inc., a subsidiary of Aston Hill Financial Inc. Mr. Ben Cheng will be the lead portfolio manager responsible for the Portfolio. First Asset Investment Management Inc. will act as the manager of the Trust.

The Trust’s investment objectives are:

(a) to provide Unitholders with quarterly distributions, estimated to initially be $0.175 per Unit ($0.70 per annum representing an annual yield of 7.0% based on the original issue price of a Unit of $10.00); and

(b) to provide Unitholders with the opportunity for capital appreciation from the performance of the Portfolio.

Geez, I hate it when the Financial Post gets desperate for copy. They consult their Journalists’ Handbook, and see that if somebody says “white is white”, it’s an interesting angle to dig up somebody who’ll say “white is black”.

They did it last year and now they’ve done it again: a short piece titled The ‘risk’ of Preferred Shares, by John Greenwood, pointing out that dividends are not guaranteed.

You can almost hear the journalist’s leading questions, which are not reported:

What would happen if a bank were to skip a payment on its preferred dividend?

If a bank were to skip one, the market for the shares would “be vaporized,” said Blackmont Capital analyst Brad Smith.

How many banks would have to skip payments before the market was adversely affected?

“All that would have to happen would be for one bank to miss a payment and the whole market would shut down,” said another analyst who asked not to be named.

Particularly irksome is:

Some European banks have been forced to cut back on dividends after accepting government bailouts.

Can he name any? I’m sure there have been some preferred defaults, but I can’t remember seeing anything about government money being conditional on a preferred dividend cut. Common dividend cuts, sure, that has happened in the States too … let’s just say I want more details.

If he wants to talk about preferred share defaults, he can look at Nortel & Quebecor World right here in Canada!

The only saving grace is:

Preferred shares rank senior to common, so even if the dividend on the common is sacrificed, holders of preferred shares could still collect. According to Sherry Cooper, senior economist at BMO Nesbitt Burns, aside from National Bank, none of the major banks has cut a dividend since the Great Depression. (National chopped twice, most recently in the early 1990s.)

… but still, I find the article annoying in the extreme. Particularly since I don’t understand why the word “risk” in the title is in quotes!

Yes, preferred shares can have their dividend cut. We know that. But if somebody’s going to talk about it in the newspaper, can we PLEASE have some kind of indication of how likely they think that might be? As for myself, I consider the probability immeasurably small for Canadian banks right now …the banks are well capitalized and profitable … anything imminent would be in the nature of a black swan event, immeasurable by definition.

Let the banks here get into trouble and sure, I’ll be happy – eager! – to start taking a view on the chances of them getting into more trouble. But could we at least wait to see some actual signs of definite trouble before discussing the effects on the market of a skipped payment?

I mean, geez, what’s next? A banner headline announcing that a giant asteroid smashing into earth could ruin our whole day?

Bloomberg has reported:

For the first time, the market will have a committee of banks and investors making binding decisions that determine when buyers of the insurance-like derivatives can demand payment and could influence how much they get, industry leaders said yesterday at a conference in New York. Traders also will revamp the way the contracts are traded, including requiring upfront payments to make them more like the bonds they’re linked to.
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The plan doesn’t change contracts traded in Europe.
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In one of the most noticeable changes for traders, those who buy protection will pay an upfront fee depending on current market prices, and then a fixed $100,000 or $500,000 annual payment for every $10 million of protection purchased. Now, upfront payments are only required for riskier companies, and the annual payment, or coupon, on most contracts is determined by the daily market level.

Dealbreaker, bless its heart, is contemptuous:

We are looking forward to the world where the only finance products permitted go up forever, and where everyone makes above average returns.

I’m mainly confused, and hoping that the Bloomberg reporters simply got it wrong. A standard up-front fee for the buyers of protection? It makes no sense. The buyer’s risk is limited to the sum of the present value of the payments required. A five year contract with a 5% premium limits the buyer’s potential loss to 25% of the notional value. The tail risk of the contract is owned by the seller of the protection, who can lose 100% of notional on the very first day the contract is in existence.

Selling protection has capital implications roughly equivalent to owning the bond. I have no problem with the idea that CDS sellers post margin equivalent to what they would have to were the position an actual bond – but most of them do already. The trouble started when the AIGs and MBIAs of this world sold protection without posting collateral or taking a high enough capital charge for regulatory purposes.

And what’s this with a fixed standard rate of $100,000 or $500,000 per year for the premium (paid by the buyer to the seller) on $10-million notional? That’s 1% and 5%, respectively. I can see that it might be very useful to standardize tick sizes, so that all contracts will trade with, say 10bp ticks … but those premia don’t make any sense.

Note that with 10bp ticks (any size ticks, actually), virtually every contract would have a value at the opening, which would be settled by cash payment between buyer and seller at the time the contract is written. I don’t have any problems with that idea – it would make contracts more fungible, particularly if settled by a clearinghouse.

But we are in the hysteria phase of CDS demonization and the politicians need a pulpit. ISDA has released a mild demur – I can only hope they’re more vociferous behind closed doors.

It was announced yesterday that JPMorgan’s analytics will go open-source; but no details of licensing have yet been released.