PrefBlog

As noted by Assiduous Reader Tobyone in the comments to a prior post, Barry Critchley of the Financial Post has published a column with a cautionary note regarding this structure: Banks Big on Reset Preferred Shares:

Over the past six months, five of the chartered banks — the Big Six less the Royal Bank–have raised more than $2-billion by way of reset preferred shares, a security they hadn’t previously sold to the public.

But the security has been around for a long time, given that BCE, for example, issued a pile of them.

The Royal Bank announced a new issue today just to ruin his column.

However, it is not strictly correct that BCE issued a pile of them. The BCE issues were reset at a proportion of five year Canadas determined by the board; the floating-rate side were ratchet-rate preferreds that could (and currently are) paying 100% of prime.

Critchley notes the inflation-mitigating effect of this structure:

In a high-inflation world, that new feature allows investors to be offered market-type rates. That feature is better than what existed with the fixed-rate perpetuals where there was no ability in a high-inflation world for investors to receive market rates.

I noted the inflation-mitigating effect of this structure in the previous post on this topic, Harry Koza Likes Fixed-Resets. Naturally, I will grant “that feature is better”. Of course it is. What else am I gonna say? The question is not whether the feature is good or not, but how good is it and how much are we paying for it?

Mr. Critchley continues:

Investors giving up yield compared with buying a fixed-rate non-reset pref share: “In essence, you are paying a premium (in terms of a lower current yield) in exchange for inflation protection down the road that won’t likely materialize unless it is clearly in favour of the issuer,” he noted. “The only thing you know for sure is that you are taking long-term credit risk with a very uncertain compensation that is currently well below fixed-rate issues.”

Exactly my point.

Update, 2008-9-9: The source for the quotations in the column was the screen-name scomac, writing in Financial WebRing Forum.

A WSJ article states:

The Treasury said its senior preferred stock purchase agreement includes and upfront $1 billion issuance of senior preferred stock with a 10% coupon from each GSE, quarterly dividend payments, warrants representing an ownership stake of 79.9% in each firm going forward, and a quarterly fee starting in 2010.

A press conference was held by Treasurey Secretary Paulson and FHFA Director Lockhart, with a press release issued by Treasury:

[Paulson said] Their statutory capital requirements are thin and poorly defined as compared to other institutions.

… but did not report his resignation.

[Lockhart said] To promote stability in the secondary mortgage market and lower the cost of funding, the GSEs will modestly increase their MBS portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 percent per year, largely through natural run off, eventually stabilizing at a lower, less risky size.

Treasury has taken three additional steps to complement FHFA’s decision to place both enterprises in conservatorship. First, Treasury and FHFA have established Preferred Stock Purchase Agreements, contractual agreements between the Treasury and the conserved entities. Under these agreements, Treasury will ensure that each company maintains a positive net worth. These agreements support market stability by providing additional security and clarity to GSE debt holders – senior and subordinated – and support mortgage availability by providing additional confidence to investors in GSE mortgage backed securities. This commitment will eliminate any mandatory triggering of receivership and will ensure that the conserved entities have the ability to fulfill their financial obligations. It is more efficient than a one-time equity injection, because it will be used only as needed and on terms that Treasury has set. With this agreement, Treasury receives senior preferred equity shares and warrants that protect taxpayers. Additionally, under the terms of the agreement, common and preferred shareholders bear losses ahead of the new government senior preferred shares.

Lockhart also disclosed some startling news:

While conservatorship does not eliminate the common stock, it does place common shareholders last in terms of claims on the assets of the enterprise.

Similarly, conservatorship does not eliminate the outstanding preferred stock, but does place preferred shareholders second, after the common shareholders, in absorbing losses.

Amazing! Common shareholders take first loss, preferred shareholders take second loss. Who would have thunk it?

Preferred stock investors should recognize that the GSEs are unlike any other financial institutions and consequently GSE preferred stocks are not a good proxy for financial institution preferred stock more broadly. By stabilizing the GSEs so they can better perform their mission, today’s action should accelerate stabilization in the housing market, ultimately benefiting financial institutions. The broader market for preferred stock issuance should continue to remain available for well-capitalized institutions.

This is interesting. Is Treasury preparing for a pre-packaged Chapter 11 at some time in the future?

Lockhart concluded:

Because the GSEs are Congressionally-chartered, only Congress can address the inherent conflict of attempting to serve both shareholders and a public mission. The new Congress and the next Administration must decide what role government in general, and these entities in particular, should play in the housing market. There is a consensus today that these enterprises pose a systemic risk and they cannot continue in their current form. Government support needs to be either explicit or non-existent, and structured to resolve the conflict between public and private purposes. And policymakers must address the issue of systemic risk.
…
In the weeks to come, I will describe my views on long term reform. I look forward to engaging in that timely and necessary debate.

Several reports are attached:

REPORTS

• FHFA Director Lockhart Remarks on Housing GSE Actions
• Fact Sheet: FHFA Conservatorship
• Fact Sheet: Treasury Preferred Stock Purchase Agreement
• Fact Sheet: Treasury MBS Purchase Program
• Fact Sheet: Treasury GSE Credit Facility

From the Preferred Stock Purchase Agreement:

In exchange for entering into these agreements with the GSEs, Treasury will immediately receive the following compensation:

• $1 billion of senior preferred stock in each GSE
• Warrants for the purchase of common stock of each GSE representing 79.9% of the common stock of each GSE on a fully-diluted basis at a nominal price

…
The following covenants apply to the GSEs as part of the agreements.

o Without the prior consent of the Treasury, the GSEs shall not:

• Make any payment to purchase or redeem its capital stock, or pay any dividends, including preferred dividends (other than dividends on the senior preferred stock)
• Issue capital stock of any kind
• Enter into any new or adjust any existing compensation agreements with “named executive officers” without consulting with Treasury
• Terminate conservatorship other than in connection with receivership
• Sell, convey or transfer any of its assets outside the ordinary course of business
  except as necessary to meet their obligation under the agreements to reduce their portfolio of retained mortgages and mortgage backed securities

• Increase its debt to more than 110% of its debt as of June 30, 2008
• Acquire or consolidate with, or merge into, another entity.

Events surrounding a potential bail-out of Fannie & Freddie, which started picking up speed after Friday’s close, appear to be nearing a crescendo.

The New York Times reports (hat tip: Financial Webring Forum) that Freddie Mac overstated capital:

The methods used to bolster that cushion have caused serious concerns among the companies’ regulator, outside auditors and some investors. For example, while Freddie Mac’s portfolio contains many securities backed by subprime loans, made to the riskiest borrowers, and alt-A loans, one step up on the risk ladder, the company has not written down the value of many of those loans to reflect current market prices.

Executives have said that they intend to hold the loans to maturity, meaning they will be worth more, and they need not write down their value.
…
Freddie Mac and Fannie Mae have also inflated their financial positions by relying on deferred-tax assets — credits accumulated over the years that can be used to offset future profits. Fannie maintains that its worth is increased by $36 billion through such credits, and Freddie argues that it has a $28 billion benefit.

But such credits have no value unless the companies generate profits. They have failed to do so over the last four quarters and seem increasingly unlikely to the next year. Moreover, even when the companies had soaring profits, such credits often could not be used. That is because the companies were already able to offset taxes with other credits for affordable housing.

This sounds totally disingenuous to me. These accounting concerns are old news; the regulators would not be in least surprised to find them on the books, they’d just pretend it was horrible startling news.

Time Business & Economics columnist Justin Fox muddies the waters with disinformation:

But what about the shareholders? It seems only fair that if the government has to step in to take over the companies, shareholders should lose everything. Except that there’s a big complication: Lots of small and mid-sized banks in the U.S. have, with encouragement from regulators, built up big holdings in Fannie and Freddie preferred stock, which they use to satisfy their capital requirements. If Fannie and Freddie preferred shares become worthless, a lot of banks will become insolvent.

However, there is one redeeming feature to that post: he quotes his source, who did not say that. :

However, the government made Fannie and Freddie preferred stock a “permissible” investment to create a sufficiently large market for these securities.

Of course, making the stock “permissible” didn’t necessarily make it attractive, so regulators had to pull another trick. Under the risk-based capital rules, national banks may carry agency preferreds at a 20 percent risk weighting (pdf file), while state-chartered banks and OTS-regulated savings associations must apply a 100 percent risk weighting. This means that banks only have to hold 1.6% or 8% capital against their investments (or should we say ‘speculation’?) in Fannie and Freddie preferred stock.
…
Thomas Kirchner is long FNM. He manages the Pennsylvania Avenue Event-Driven Fund [PAEDX], which is long and short various FNM and FRE securities. He is a former FNM employee.

Mr. Kirchner in turn cites the OCC Publication “Activities Permissable for a National Bank”:

Fannie Mae and Freddie Mac Perpetual Preferred Stock. A national bank may invest in perpetual preferred stock issued by Fannie Mae and Freddie Mac without limit, subject to safety and soundness considerations. OCC Interpretive Letter No. 931 (March 15, 2002).

It should be noted that there is nothing in the cited document to support the assertion of 20% risk weight … PrefBlog’s Assiduous Readers, however, will have read my post Fannie Mae Preferreds: Count Towards Bank Capital? in which some support for the 20% risk-weight figure was unearthed.

Naked Capitalism linked to a John Dizard column in the Financial Times:

Last week I wrote about these preferreds; my position was that if or, rather, when the Treasury had to recapitalise the GSEs with new, senior preferred issues, it would be a really good idea from the taxpayers’ point of view to leave the old preferreds in place while wiping out the value of the outstanding common stock.

… which is not inconsistent with the solution I see as best, but his original column was not very specific:

Still, to the point raised by Peters and the other cautionary voices, there are answers. First, Fannie Mae and Freddie Mac need to be nationalised, in the sense that the federal government injects capital in the form of preferred equity and direct credit support, wiping out the existing common. I believe it is critical that that takeover leaves the privately held preferred stock of the government-sponsored enterprises in place. Preserving the value of GSE preferred issues is very much in the taxpayers’ interest, as it makes possible the recapitalisation of the rest of the banking system.

Very interesting, but just macro-style generalities.

However, the Wall Street Journal has reported:

U.S. Treasury Secretary Henry Paulson and Federal Housing Finance Agency Director James Lockhart are expected to release details of the planned conservatorship of Fannie Mae and Freddie Mac at an 11 a.m. press conference in downtown Washington.

More when I know more …

Update: See Fannie & Freddie Plan Released: Treasury Follows PrefBlog’s Plan!

Harry Koza titled his G&M column of today Back to the 70s: We haven’t seen spreads this wide since Carter, in which he states (emphasis added):

tapping the market right after their third-quarter earnings in late August with five-year rate reset preferred share issues (TD, Scotiabank, BMO and CIBC).

Those are interesting. You get a nice dividend for the first five years, ranging from 5 per cent for TD and Scotiabank, to BMO at 5.2 per cent and CIBC at 5.35 per cent. At the end of five years, the dividend resets at a juicy spread over whatever a five-year Government of Canada bond yields at that time – the CIBC one resets at 218 basis points over Canadas. Of course, they are redeemable on every five-year anniversary date as well, so if the current historically wide yield spreads have reverted to precredit crunch levels by then (which, to my jaundiced view of the current credit conflagration, is no better than an even money bet) and the bank can refinance cheaper, they will call them away from you, and you’ll have to reinvest elsewhere, possibly at lower yields.

Still, they are worth a look for taxable income investors. Good credits, decent yield, five-year term. Gee, I almost want to buy some myself.

Five-year term? I’m sure that is how they’re being sold, but I will continue to refer to them as having a “pretend-5-year-term”. If they turn out to be awful investments, they will turn out to be very-long-term instruments.

In a a discussion on FWR the point was made:

Won’t the fact that the issuer may call if there is inflation be a good thing? as unlike a perpetual, all things being equal it keeps the price closer to issue price.

Well, first I’ll make the point that these fixed-reset issues are perpetual. They simply have a dividend that resets. The credit risk is perpetual.

But what will happen if there is inflation? We can expect the Government of Canada 5-year bond yield and 90-day T-bill yield to increase to provide some kind of real yield; and then there will be a credit spread (of varying size) to be added to that. So, yes, one must agree: fixed-reset perpetuals offer a degree of protection against inflation-risk that is not present with “straight” (fixed dividend) perpetuals.

We’re investors, however. The question, as always, is not “Is there risk?” but rather “How much risk, of what particular kinds, is there and how much am I getting paid to take it?”. Given that straight perpetuals now yield about a point – maybe a bit more – over the initial fixed-reset rate, we can say we’re being paid 100 basis points (annually!) to take on that inflation risk.

Some investors may think that’s not enough. Some investors may think it’s very generous. I feel that central banks, globally, learned their lessons very well in the 1970s and that at the present time the Bank of Canada can be trusted to take their inflation mandate seriously (and that politicians can be trusted not to change the mandate).

Is this a guarantee? Am I therefore recommending a 100% holding in straight perpetuals? Of course not. There are no guarantees in either life or investing … inflation risk is forever with us (to some degree or another) and the question is: how do we set up a total portfolio that will allow us to achieve our goals in the face of a wide spectrum of risks – including, but not limited to, inflation.

While I will not condemn the Fixed-Reset Asset class completely – I will not condemn any asset class completely, everything has a price – I will suggest that perpetual preferreds are not the most logical choice of inflation hedge, even if they reset.

Fixed-Resets have attracted a wide variety of views, which I have endeavored to present on PrefBlog:

• Critchley Credits Desjardins for Fixed-Reset Issues
• Critchley of Financial Post: Fixed-Resets Good!
• Fixed-Resets : Critchley Likes, Ruggins Doesn’t
• and my own: Research: Analysis of Perpetual Resets

Make your own minds up and don’t – ever – make any bets you can’t afford to lose.

Update: As stated above, inflation is a risk. But so is deflation:

Other economists anticipate a calamitous deflation. Albert Edwards, economist strategist at Société Générale, the Paris-based investment bank, says an apocalyptic deflation will hit the global economy next year, cutting through equity assets “like Freddy Krueger.”

Michael Mandel, a PhD economist who writes for BusinessWeek magazine, predicts the rapid withering of inflation. “A year from now, will we be talking about galloping inflation or a plunge into deflation?” he asks. “I think the odds favour deflation or, at least, lower inflation. Producer price inflation in the traditional service industries is now only 0.6 per cent on a year-over-year basis – and the majority of the [U.S.] economy is services, not manufacturing. [This measure] is the best gauge of inflation that we have.”

There’s always more than one risk! Deflation will, of course, boost straight perpetuals – at least by the amount of their discount, at least until the first call date.