PrefBlog

The Fannie & Freddie reporters highlighted what they believe to be startlingly new information today – sub-debt does not default with deferred dividends:

Buyers of credit-default swap contracts that protect against losses on Fannie Mae or Freddie Mac subordinated debt may not get paid immediately if the mortgage-finance companies were to defer interest payments as part of a government bailout, according to Bank of America Corp.

While a failure to make the payments permits credit-default swap buyers to cash in on their protection, Freddie and Fannie subordinated bond indentures allow interest to be deferred for as long as five years, or until maturity, if capital cushions breach certain thresholds, Bank of America strategist Glen Taksler in New York wrote in a note to clients yesterday.

Bank sub-debt has been discussed on PrefBlog before, as have Credit Default Swaps. The place of sub-debt in a bank’s capital structure has been mentioned in a review article.

But Citigroup says ‘calm down, people!’:

Fannie Mae and Freddie Mac can withstand losses through the end of the year and still keep a cushion above their minimum capital requirements, according to Citigroup Inc. analysts.

Freddie of McLean, Virginia, will have $12.7 billion of capital above the minimum requirement, according to slides provided by Citigroup for a conference call with investors. Washington-based Fannie will have $20.3 billion.
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The bank’s interest rate strategists led by Scott Peng in New York said last week that the beleaguered mortgage-finance companies don’t need to be nationalized and the U.S. should resist being “stampeded” into a bailout.

Speaking of Fannie, I am thrilled to announce that I have finally seen a definition of “wiped out”, as used in the phrase “Fannie Mae preferred shareholders may get wiped out!!!!!”. According to Dealbreaker:

There had been widespread fear that a government rescue of Freddie would wipe out the preferred shareholders, possibly by subordinating them to new government-owned preferred shares.

I fail to see how the simple fact of subordination to another series of prefs can be equated to a “wipe out”. They’re already subordinated to sub-debt and ordinary liabilities. Would the phrase “wipe out” continue to apply if it was simply more sub-debt being loaded on to the balance sheet? As I discussed on August 22, in the absence of (a credible threat of) liquidation or expropriation, any talk of a preferred share wipe-out at Fannie Mae is simply hysterical nonsense.

If you want to say that Fannie Mae will be liquidated with little or no value to the preferred shareholders, that’s one thing to argue. Or Treasury making an offer they can’t refuse with the threat of liquidation, that’s another. Or Treasury simply expropriating the preferred shares, that’s a third avenue of argument. But simple, straightforward subordination is not equivalent to wipe-out unless one of those arguments holds.

Freddie was downgraded by S&P today:

Standard & Poor’s Ratings Services said today that it affirmed its ‘AAA/A-1+’ senior unsecured debt rating on Freddie Mac with a stable outlook. At the same time, we lowered the risk-to-the-government stand-alone issuer credit rating to ‘A-‘ from ‘A’, the subordinated debt rating to ‘BBB+’, and the preferred stock rating to ‘BBB-‘ from ‘A-‘. The ratings that were lowered are all placed on CreditWatch Negative.
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It could be straightforward funding support through expansion of the Treasury line, buying Freddie Mac’s debt or its agency mortgage-backed securities, or it could consider an equity investment. The possibility of an equity investment is driving Freddie Mac’s equity price lower and the yield on its preferred stock higher. An equity investment by
Treasury could be accompanied by the consideration of nonpayment of existing preferred stock and common dividends.

The subordinated notes pose incremental risk to investors because of an interest deferral feature given certain trigger events tied to Freddie Mac’s regulatory capital levels. The subordinated debt covenant language also states that a deferral of the subordinated debt interest payment triggers the nonpayment of all preferred stock and common dividends, arguing for a close alignment of preferred stock and subordinated debt ratings. However, we now rate the preferred stock two notches below the subordinated debt to reflect the increased risk of nonpayment of dividends as a means of capital preservation. Furthermore, there are no covenants restricting the payment of interest on the subordinated debentures, while the preferred dividends are suspended.

The language is fairly similar in the release announcing the downgrade of Fannie Mae. I must say, a downgrade from A- to BBB- for the preferred stock given the potential for a suspension of the preferred dividend seems to me to be a far more appropriate response than hysterical screaming about wipe-outs.

But!

Wait a minute!

I just remembered!

S&P, in its role as Evil Credit Rating Agency, is paid by the issuer! Geez, that sounds terrible.

And there’s a somewhat related story that Lehman is trying to sell or spin-out-for-cash its Commercial Mortgage assets.

Accrued Interest has engaged in some blue-sky thinking about the GSEs; there’s much with which I disagree:

its looking more and more like a bailout isn’t imminent (meaning its a matter of weeks or months, not days). I expect an interim step, probably some kind of purchase of MBS, to come before any actual injection of cash.

I don’t think there will be any interim step; I think such action would be economically and idealogically indefensible.

A big part of the inherent problem in the GSEs’ current business model is that it requires substantial leverage to generate a reasonable return on equity. Think about it. They collect a relatively small fee in exchange for guaranteeing MBS. The de facto leverage created is huge, evidenced by the fact that foreclosure rates in Fannie and Freddie’s guarantee portfolio remain fairly low, and yet both GSEs are facing capital problems. There is just no way around the leverage issue if the current business model remains in tact.

Well … yes there is. The fee can become larger. And structural reforms in US mortgages are urgently needed:

Americans should also be taking a hard look at the ultimate consumer friendliness of their financial expectations. They take as a matter of course mortgages that are:

• 30 years in term
• refinancable at little or no charge (usually; this may apply only to GSE mortgages; I don’t know all the rules)
• non-recourse to borrower (there may be exceptions in some states)
• guaranteed by institutions that simply could not operate as a private enterprise without considerably more financing
• Added 2008-3-8: How could I forget? Tax Deductible

But Accrued Interest‘s main suggestion is:

Covered bonds have been advanced as a long-term solution for the mortgage market. But covered bonds, as currently conceived, would not be a good replacement for agency MBS. This is because covered bonds would not trade generically, meaning that a covered bond from smaller banks would trade as well as those from larger banks. We’d wind up with large banks dominating the mortgage market, which has its own systemic risk problems.

So what if in the future the GSEs provided some limited guarantee on covered bonds?
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This a plan combines the best parts of both the covered bond idea (alignment of incentives) and the original mission of the GSEs (lowering mortgage rates). It would also kick-start the emergence of a covered bond market, because it would give investors a known set of outcomes when buying the new bond sector.

It’s a very interesting idea … I’ll have to think about it a bit more. My first thought is that covered bonds are generally AAA anyway – how much could the GSEs charge for adding another layer of protection?

Covered bonds have been recently approved by the FDIC and were discussed on PrefBlog last fall.

When reviewing the 3Q08 BMO Financials, I noted that they were keeping assets constant while beefing up their capital – thus engaging in some gentle delevering. Bank borrowing is getting expensive:

Banks, securities firms and lenders have a record $871 billion of bonds maturing through 2009, according to JPMorgan Chase & Co., just as yields are at their most punitive compared with Treasuries. The increase in yields may cost them as much as $23 billion more in annual interest versus a year ago based on Merrill Lynch index data.

Higher refinancing expenses will restrict the ability of banks to borrow in the capital markets and lend, further cutting off credit to consumers and businesses and curbing what is already the slowest growing economy since 2001. Standard & Poor’s said last week that it had a “negative” outlook on almost half of the 50 highest-rated financial institutions in the U.S. as of June 30, the highest proportion in 15 years.

PerpetualDiscounts eased off a bit today, on reasonably average volume. What should I say? According to “Investment Punditry for Dummies”, I could say “profit taking”, “concern about this week’s bank earnings announcements”, “making room for a new BNS issue” … there’s lots of choices! I think I’ll just say “I have no idea. Ask a priest!” and leave it at that.

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

Freddie Mac had a gushing review on Bloomberg today:

Freddie Mac rose 17 percent in New York trading after a $2 billion sale of short-term debt stoked confidence the second-largest U.S. mortgage-finance company can still attract investors.
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Freddie Mac sold $1 billion of three-month notes at a yield of 2.58 percent, the company said today. That translates to about 90 basis points more than similar-maturity U.S. Treasuries and 23 basis points less than the three-month London interbank offered rate. The spreads from last week’s sale were 61 basis points over Treasuries and 32 basis points below Libor, according to Stone & McCarthy Research Associates.

The company also sold $1 billion of six-month debt at a yield of 2.858 percent, a spread of about 92 basis points above Treasuries and 25.5 basis points below Libor; compared with 80 basis points and 32 basis points last week. A basis point is 0.01 percentage point.

Well … it’s nice that they were able to finance through LIBOR, but let’s not get carried away! Let’s see how well they can finance the next month’s needs:

Fannie has about $120 billion of debt maturing through Sept. 30, while Freddie has $103 billion, according to figures provided by the companies and data compiled by Bloomberg.

… on the bond market, rather than the Money-Market, before breaking out the champagne. Unless my trusty calculator has let me down, $2-billion is less than half their daily quota until September 30 … each.

Fortunately for oenophiles, there is an excuse for some bubbly. PerpetualDiscounts were up 21bp today, bringing the total return index back to slightly above its June 30 levels … OK now it’s time to start working on June (a really, really lousy month).

The perpetualDiscount index now has a weighted average mean yield to maturity of 6.11%, equivalent to 8.55% interest at the standard 1.4x equivalency factor. Long corporates now yield in the 6.15-6.20% range, so the pre-tax interest-equivalent spread is now about 235bp.

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

Update: Dealbreaker passes on a rumour that Fed Pressures Treasury Not To Wipe Out Fannie Mae Preferreds:

The Federal Reserve has been quietly pressuring the Treasury Department not to adopt a rescue plan for Fannie Mae and Freddie Mac that would wipe out the value of their preferred shares, according to a source familiar with the matter. The Fed fears that any move that hurt the preferred could worsen the crisis in regional banks that is already under way.
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The situation is complicated, however, by the large share of preferred stock held by regional banks, many of which are viewed as possible candidates for failure in these credit crunched times. As the Financial Times reported over the weekened regional banks and US insurers hold the majority of Fannie and Freddie’soutstanding preferred stock. The Fed has begun advocating against wiping out these shares, saying the threat to stability of the banks is greater than the ‘moral hazard’ argument, a source familiar with the matter says.

As usual, it’s not clear what is meant by “wiping out”.

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.
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Moody’s believes these firms currently have limited access to common and preferred equity capital at economically attractive terms.
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The downgrade and continued review for further downgrade of the preferred stock ratings reflects a greater risk of dividend omission on the preferred stock.
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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.

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