PrefBlog

Bloomberg reports that Citigroup is about to offer a new issue of TruPS:

The 30-year fixed-to-floating rate securities may initially yield about 8.875 percent, according to a person familiar with the offering who declined to be identified because terms aren’t set. Citigroup plans to issue as much as $2 billion of the securities as soon as tomorrow, another person said.
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Citigroup’s $2.35 billion of 8.3 percent fixed-to-floating bonds due in 2057 rose 1.4 cent to 96.5 cents on the dollar, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The hybrid debt has more than tripled in price in the last year from 30.5 cents, Trace data show.

What makes this interesting is a novel (to me!) clause in the prospectus:

On December 17, 2009, the Basel Committee on Banking Supervision (“Basel”) proposed, among other proposals, revisions to its definition of Tier 1 capital for banks. Provided certain other conditions more fully described in “Description of the Capital Securities — Special Event Redemption” below are satisfied, the adoption of, or announcement of intent to adopt, Basel’s revised definition of Tier 1 capital by the Capital Regulator could qualify as a Regulatory Capital Event (as defined herein) that would permit Citigroup Capital to redeem the capital securities.
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This prospectus refers to a Tax Event, an Investment Company Event or a Regulatory Capital Event as a “Special Event.” Provided that Citigroup obtains any required regulatory approval, if a Special Event occurs and continues, Citigroup may, upon not less than 30 nor more than 60 days’ notice, redeem the junior subordinated debt securities, in whole or in part, for cash within 90 days following the occurrence of such Special Event. Following such redemption, trust securities with an aggregate liquidation amount equal to the aggregate principal amount of the junior subordinated debt securities so redeemed shall be redeemed by Citigroup Capital at the redemption price on a ratable basis. If, however, at the time there is available to Citigroup or Citigroup Capital the opportunity to eliminate, within such 90-day period, the Special Event by taking some ministerial action, such as filing a form or making an election or pursuing some other similar reasonable measure that will have no adverse effect on Citigroup Capital, Citigroup or the holders of the trust securities, then Citigroup or Citigroup Capital will pursue such measure instead of redemption and provided further that in the case of a Regulatory Capital Event, where a result of which is that only a portion of the capital securities will not qualify as Tier 1 capital of Citigroup, Citigroup may redeem an amount of junior subordinated debt securities up to the amount that corresponds to the capital securities that would no longer qualify as Tier 1 capital as a result of such Regulatory Capital Event.

The December 17 proposal has been reported on PrefBlog. The sticking point in the proposed revisions is, I believe, Criteria for inclusion in Tier 1 Additional Going Concern Capital #4:

Is perpetual, ie there is no maturity date and there are no incentives to redeem

whereas the prospectus states:

The capital securities have no stated maturity date but will be redeemed upon the maturity of the junior subordinated debt securities, or earlier on the dates and to the extent the junior subordinated debt securities are redeemed. See “Description of the Junior Subordinated Debt Securities — Optional Redemption.” The junior subordinated debt securities will mature on , 2040, and may be redeemed, in whole or in part, at any time on or after , 2015 at a redemption price equal to 100% of the principal amount being redeemed, plus accrued and unpaid interest through the date of redemption. The junior subordinated debt securities can also be redeemed at any time, in whole or in part, in certain circumstances upon the occurrence of a Tax Event, an Investment Company Event or a Regulatory Capital Event (each as defined below) at a redemption price equal to 100% of the principal amount being redeemed, plus accrued and unpaid interest through the date of redemption.

If then required, Citigroup will obtain the concurrence or approval of the Capital Regulator before exercising its redemption rights prior to the maturity date Upon the maturity of the junior subordinated debt securities, the proceeds of their repayment will simultaneously be applied to redeem all outstanding trust securities at the redemption price. Upon the redemption of the junior subordinated debt securities, whether in whole or in part, either at the option of Citigroup or pursuant to a Tax Event, an Investment Company Event or a Regulatory Capital Event, Citigroup Capital will use the cash it receives upon the redemption to redeem trust securities having an aggregate liquidation amount equal to the aggregate principal amount of the junior subordinated debt securities so redeemed at the redemption price. Before such redemption, holders of trust securities will be given not less than 30 nor more than 60 days’ notice. In the event that fewer than all of the outstanding capital securities are to be redeemed, the capital securities will be redeemed on a ratable basis as described under “— Book-Entry Only Issuance.” See “— Special Event Redemption” and “Description of the Junior Subordinated Debt Securities — Optional Redemption.” If a partial redemption of the capital securities resulting from a partial redemption of the junior subordinated debt securities would result in a delisting of the capital securities, Citigroup may only redeem the junior subordinated debt securities in whole.

The Capital Securities are what’s being sold to the public; the Junior Subordinated Debt Securities are what the vehicle holds to secure payments to the Capital Security holdes (i.e., this is a loan-based IT1C).

Update: Whisper yield cut to 8.5%:

The bank plans to issue $2 billion of the securities, known as TruPS, as soon as today, according to a person familiar with the offering who declined to be identified because terms aren’t set. The 30-year fixed-to-floating rate securities may initially yield about 8.5 percent, lower than the 8.875 percent expected yesterday, another person said.

Penny Algorithms are automated trade entry systems that will improve the posted quote of a security by a penny.

They’ve been mentioned on PrefBlog several times:
GAndreone:

In addition I find that order placed via my discount broker sometimes are overtaken by “trading robots”. That is, a buy order places at lets us say 1 cent above the highest order showing on level 2 quotes never makes the top of the list. A new smaller order appears at 1 cent above the order just placed. If you remove the order the smaller order also disappears.

Annette:

Are those orders “automatized” or is there a trader watching all day long the stock? As soon as you buy the 2, 5 or 10 lots where the iceberg lies, it is almost immediately topped off with more lots. I sometimes play with it putting a bid one cent lower (sell order) or higher (buy order) to see it going almost immediately one cent in front of me. It will better me up to a certain point. I witdraw mine it goes back to where it was. I sometimes suspect it is one of you guys playing games.

I am currently engaged in a dispute regarding the very existence of penny algorithms for preferred shares (arising from an article on Pegged Orders that is now in preparation), and ask that those who notice one in operation for the next week or so either eMail me or tell me about it in the comments.

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!

According to Reuters:

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:

Assume the preferreds are bought back for half of face value. Then:

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!

It’s interesting:

1. Preferred Shares and GICs

2. Perpetual and Retractible Preferred Shares

3. Corporate Bonds … or Preferred Shares?

4. Interest Bearing Preferreds

5. Why Invest in Preferred Shares?

6. A Brief Introduction to Preferred Shares

7. The Future of Money Market Fund Regulation

8. Trading Preferreds

9. Modified Duration

10. Dividends and Ex-Dates

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”.
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Notching for Deferral or Skipping of Payments

DBRS 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.
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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.