I was reminded of this topic recently … and reminded some time ago of the perception of relative risks when investing in preferred stock. A stockbroker type was explaining to me that he would never buy bank preferreds due to the risk of default … I pointed out that, while always possible, the banks would surely cut or eliminate their common dividend well in advance of their preferred dividend.
He was flabbergasted … “Do you really think they would cut their dividend? That would be terrible!”
In other words, he very calmly accepted the idea of a default on the perpetuals, but could not conceive of a situation in which a bank would cut its common dividend.
Recently, the poster-boy for credit excesses, Citigroup, cut its common dividend 41% while the preferred dividends just kept on chugging along – even increased in total, as they have raised a lot of capital via preferred offerings … presumably to investors who figured they wanted their interim dividends for the next five-years-odd to be preferred!
So anyway, I was thinking about this a little more and did a little digging … through the RBC Annual Report for 2007:
During 2007, we continued to return capital to our shareholders through dividend increases and share buybacks, delivering a total shareholder return of 16 per cent.
…
For several years, we have made it a management priority to ensure current success was reinvested to fund future growth. This approach allowed us to deliver relatively solid shareholder returns in 2007 while returning capital through increased dividends and share buybacks. We raised dividends twice in 2007 for a total increase of 26 per cent, and we repurchased 11.8 million common shares. Our capital position is strong with a Tier 1 capital ratio of 9.4 per cent, comfortably above our target of greater than 8 per cent.
Share Buybacks are analytically equivalent to dividends – and buyback-suspensions are the easiest way to halt a decline in capital ratios. But what sort of proportion do they make? I’ve had a preliminary look at this via RBC’s Annual Reports for 2001, 2004 and 2007:
| RBC Data | ||||
| Year | Income | Preferred Dividends |
Common Dividends |
Common Buy-Backs |
| 1999 | 1,725 | 157 | 588 | 333 |
| 2000 | 2,208 | 134 | 689 | 660 |
| 2001 | 2,435 | 135 | 897 | 509 |
| 2002 | 2,898 | 98 | 1,022 | 764 |
| 2003 | 3,036 | 68 | 1,137 | 852 |
| 2004 | 2,839 | 45 | 1,303 | 892 |
| 2005 | 3,387 | 42 | 1,512 | 226 |
| 2006 | 4,728 | 60 | 1,847 | 844 |
| 2007 | 5,492 | 88 | 2,321 | 646 |
| Total | 11,316 | 5,726 | ||
So, this is all pretty rough, it’s only one bank (a strong one!) and it’s taken over a period in which the bank examined hasn’t had anything particularly horrible happen to it. Still, it’s interesting to find that about 1/3 of the total capital returned to common shareholders has been in the form of buybacks rather than dividends … and, as the experience of 2005 shows, the buybacks can be cut quite easily.
I believe National Bank of Canada was the last Canadian bank from the Big 6 to cut its dividend, and it happened in the early 1990s. If I remember correctly, they cut their common dividend in half at that time.
They had recorded heavy losses in real estate, including a loan to Campeau Corporation, and they were still trying to recover from the losses on their loans to some third world countries. The icing on the cake was an unexpected loss of over $20 million from their trading desk in the United States.
I think the yield on their preferred shares temporarily went up as a result of these tremors, but I can’t tell for sure. If anyone would be interested to research this subject, look for the period from about 1990 to 1993: that would be about the time National Bank cut its common dividend (and more probably 1991 or 1992).
I am looking at investing in preferred shares and find myself asking this question about the chance of default. I have a pretty good handle on the chance of the bank failing outright and losing all their equity. I think this is small enough to make it worth the risk given that the yield is double digit.
However the bank (I will leave it anonymous for now) has reduced the common dividend to a token amount to preserve capital. I think they will muddle through 2008 and return to decent profitability in 2009. The management owns 30% of the common shares and so has a strong incentive to collect common dividends, protect the common equity and avoid dilution. Preferred equity is nearly equal to common equity so preferred dividends are significant reductions to capital.
However, the question that I have is, What incentive do they have to pay preferred dividends? They could cut both dividends and just grow the banks capital for a few years. This would benefit common shareholders enormously but preferred holders would lose out. Would this be considered unfair treatment of preferred shareholders? What would be the downside of this for management? I would guess the only downside would be loss of respect and a reduced ability to raise preferred capital in the future. Do they have any incentive to instead keep paying preferreds and sell common shares to pay for it? I am missing something important?
Thanks in advance.
Well, not knowing the bank (I know you follow a lot of US banks, some in PR) I can’t really say a lot, but I can attempt some guesses!
I’m sure the preferred shareholders would consider an unnecessary dividend cut to be unfair! Whether or not a court would consider it unfair is dependent upon the applicable law and the terms of the issue … but I suspect that, legally, there would be nothing wrong with it.
However, it is almost certain that the preferred dividend cannot be touched unless the common dividend goes to zero. A zero dividend will look very bad for future investors – I suspect that a token dividend is worth a lot more than just a few tokens!
Also, it is possible – barely – that the preferred dividends are cumulative, which would reduce the attractiveness of cutting the preferred dividend substantially.
Additionally, cutting the preferred dividend would – probably – give the pref holders additional rights … perhaps a guaranteed seat or two on the board of directors, perhaps full voting rights. If preferred equity is “nearly equal to common equity”, then there’s some chance that full voting rights could give the pref holders control of the company – if management is currently in a control position, this would be even more unpalatable for the current board than usual.
And, as you say, if the preferred dividend was cut without really sufficient justification, they will find it extremely difficult to issue any more. This will greatly restrict management’s options more than is already the case.
But your first step is to examine the prospectus for the prefs and find out how their rights change when dividends are missed.
Thanks for the thoughtful reply. The bank is Westernbank of Puerto Rico (WHI:NYSE) and the prefs are WBPR[K,M,N,Z,J,L] recently delisted from NASDAQ. They are extremely illiquid. I am picking up a few at 20% yields. I am guessing institutions are just dumping them indiscriminately due to the bank not being current on SEC filings as well as the general deleveraging going on. I am wondering who besides me would buy such things. Hedge funds?
Yeah it is a non-cumulative perpetual preferred dividend. The prospectus indeed prohibits common dividends if the 12 monthly perpetual dividends were not payed in full. It appears that default on the prefs gives them the right to add an additional director to the BOD. I believe there are 6 or so directors. It does not say anything about full voting rights so I don’t think the prefs could take control. One director is better than none but probably does not protect pref shareholders very much.
I think the managers of this bank consider issuing preferred shares as the bank grows to be a permanent strategy so I don’t think they want to ruin their reputation with regard to not issuing preferred dividends. They have already hurt it some by letting the prefs get delisted from NASDAQ due to delays in SEC filings due to restatement. They will need to build common equity for a few years but may want to issue prefs in the future.
They have managed to grow the bank very quickly over the past 10 years by using preferred shares as an additional leverage factor on common equity. Naturally leverage has its downside when times are tough but I think they will muddle through.
So I think I am coming to the conclusion that there is not much risk besides 1) complete bank failure and 2) liquidity risk. I am getting a 20% dividend yield so I am not worried about liquidity risk. I am happy holding a 20% yielding instrument forever if need be. Complete failure is possible of course but I am willing to take that risk. Mostly likely, management would sell the bank or dilute common if things get very bad. If they get even worse, well that’s life.
There is the risk that they forego preferred dividends for a year or so but I don’t see that going on for very long. Plus, I am a common shareholder also so that would benefit me anyway.