August 20, 2008

Excitement over the Fannie and Freddie preferreds continues, with Accrued Interest noting in a late post that they showed good strength in the last hour of trading yesterday.

Amidst all this talk about how the preferred shareholders could be hurt by a bail-out, I think it’s time to take a better look at the mechanics of how they could be hurt. What can be done to them?

It’s easy to figure out how to hurt the common shareholders. Their dividend has already been slashed, the companies could just walk to the end of that road and cut it completely. After that, they could be diluted all to hell – for instance, the Treasury could backstop an issue of senior preferreds, convertable into common at $1. Presto! Permanent impairment for the common holders.

But pain by dilution is not a worry for the preferred shareholders. They have a claim for $X annual dividend and $Y liquidation value on the company, and that claim is not affected by how many prefs are outstanding. The enforcibility of that claim is affected – there’s the potential, for instance, for a liquidation to pay less than 100% – but (a) the claim is unchanged and (b) the company needs to be liquidated for this to happen. Liquidation is the ultimate step and will be a political decision – I don’t consider it too likely, frankly, but make up your own minds.

Another possibility is an offer they can’t refuse – as happened with the Thornberg prefs reported on PrefBlog on July 22. They were given the opportunity to exchange into a new series at twenty cents on the dollar, and all sorts of horrible outcomes were threatened if they didn’t accept. They had to accept; in liquidation they almost certainly would have gotten less, while there was an offer on the table to recapitalize the company provided they allowed impairment of their claim.

Is this scenario a valid fear for the Fannie and Freddie prefs? Well, make up your own minds – there’s plenty of people willing to state pseudonymously on the internet that everything is worthless. I’m not convinced. If such an offer were to be made to the Fannie and Freddie prefholders, I think that they could very well win a staring contest.

The most likely scary scenario that their dividends get cut off. This is basically the only action the company can unilaterally take – but it means no dividends to the common shareholders, either. Not a single penny until the preferred dividends re-start; and there may be other remedies in the prospectuses that I haven’t read. Such an action will make the common a little difficult to sell, eh? Even at $1.

And finally, Treasury could simply expropriate their rights – re-write the law and do whatever they like. Frankly, I don’t consider this a credible outcome; not when the base-case scenario of issuing senior, convertable preferred accomplishes the policy objective of wiping out the common shareholders and recapitalizing the company. If Treasury wants to punish the preferred shareholders, they might insist that dividends get suspended for ‘the duration of the crisis’; interested readers may work out for themselves what the yields are when dividends are suspended for a variety of periods. Sadly, all series of FNM prefs are non-cumulative – I haven’t done much investigation of the particulars, but I did check that!

Note that this is not intended to be an endorsement of the Fannie and Freddie prefs – I haven’t looked at the financials for myself and I haven’t parsed all of the political statements for myself. I am merely trying to point out that the common shareholders’ pain will not necessarily be transmitted 100% to the preferred shareholders.

However, Accrued Interest posted his latest thinking on the issue today – interestingly, his plan is very pref-favourable, and involves recapitalizing the GSEs to bank levels, although he does not explicitly support my desired outcome of turning them into banks, plain and simple. He notes:

Today both Fannie Mae and Freddie Mac management are meeting with Treasury officials. My take is that Treasury is setting a deadline for them to raise new capital before the Treasury acts.

As far as the common goes … well, the short interest is something fierce!

Marco Onado of Boccini University, Milan, writes a good review article in VoxEU regarding Bank Losses and Capital. He makes the points:

  • Total assets grew much faster than the risk-weighted assets against which banks must hold capital – in other words, there is a good indication that European investment banks were “gaming the system”, by concentrating on assets with a low risk weight as defined by the Basel accords. At the same time, the Assets to Capital multiple of these players increased dramatically.
  • The tangible component of equity decreased, which means that a part of the capital cushion was largely made of intangible assets deriving from the merger process within the banking system.
  • new capital trails write-downs (i.e. the emergence of unexpected losses) by some $ 100 billion (See the IMF July Update to the Global Financial Stability Report)
  • Much of the capital has been replaced with hybrid instruments (e.g., preferred shares and Innovative Tier 1 Capital), which has a lower equity content than the 100% equity content of the losses

Basically, he wants more regulation in future:

But regulators must face the hard truth, as Merrill Lynch did: “the credit crisis has destroyed the idea that unregulated financial markets always efficiently channel savings to the most promising investment projects”. This means that regulation must be thoroughly revised and capital adequacy rules must be strengthened

I must point out that his interpretation is logically fallacious. The failure of capital markets to achieve 100% efficiency does not imply that their level of efficiency can be increased by central planning. It could be – I’m willing to grant that much – I’ll listen to arguments! But it’s a non-sequiter.

PerpetualDiscounts had their second straight down-day on light volume.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet N/A N/A N/A N/A 0 N/A N/A
Fixed-Floater 4.62% 4.37% 56,304 16.43 7 +0.0116% 1,107.0
Floater 4.04% 4.08% 44,197 17.20 3 +0.3121% 913.0
Op. Retract 4.97% 4.26% 110,766 2.67 17 +0.0542% 1,048.1
Split-Share 5.35% 5.91% 55,889 4.37 14 -0.0373% 1,038.9
Interest Bearing 6.26% 6.77% 48,719 5.24 2 -1.1475% 1,118.8
Perpetual-Premium 6.15% 5.97% 69,713 2.23 1 +0.3160% 993.6
Perpetual-Discount 6.08% 6.14% 194,188 13.53 70 -0.0733% 875.0
Major Price Changes
Issue Index Change Notes
BNA.PR.B SplitShare -2.9297% Asset coverage of 3.3+:1 as of July 31, according to the company. Now with a pre-tax bid-YTW of 9.24% based on a bid of 19.26 and a hardMaturity 2016-3-25 at 25.00. Compare with BNA.PR.A (6.10% to 2010-9-30) and BNA.PR.C (9.26% to 2019-1-10).
BSD.PR.A InterestBearing -2.3590% Now with a pre-tax bid-YTW of 7.19% (mostly as interest) based on a bid of 9.52 and a hardMaturity 2015-3-31 at 10.00.
HSB.PR.D PerpetualDiscount -1.3468% Now with a pre-tax bid-YTW of 6.20% based on a bid of 20.51 and a limitMaturity.
POW.PR.C PerpetualDiscount -1.2521% Now with a pre-tax bid-YTW of 6.21% based on a bid of 23.66 and a limitMaturity.
GWO.PR.G PerpetualDiscount -1.2385% Now with a pre-tax bid-YTW of 6.15% based on a bid of 21.53 and a limitMaturity.
CU.PR.B PerpetualDiscount -1.1858% Now with a pre-tax bid-YTW of 5.99% based on a bid of 25.00 and a limitMaturity.
BAM.PR.N PerpetualDiscount -1.1855% Now with a pre-tax bid-YTW of 7.27% based on a bid of 16.67 and a limitMaturity.
PWF.PR.I PerpetualDiscount -1.0848% Now with a pre-tax bid-YTW of 6.15% based on a bid of 24.62 and a limitMaturity.
NA.PR.M PerpetualDiscount +1.0183% Now with a pre-tax bid-YTW of 6.09% based on a bid of 24.80 and a limitMaturity.
TRI.PR.B Floater +1.0213%  
ELF.PR.G PerpetualDiscount +1.2564% Now with a pre-tax bid-YTW of 6.80% based on a bid of 17.73 and a limitMaturity.
Volume Highlights
Issue Index Volume Notes
BNS.PR.K PerpetualDiscount 105,180 Nesbitt crossed 100,000 at 21.25. Now with a pre-tax bid-YTW of 5.71% based on a bid of 21.24 and a limitMaturity.
GWO.PR.G PerpetualDiscount 34,646 Nesbitt crossed 25,000 at 21.81. Now with a pre-tax bid-YTW of 6.15% based on a bid of 21.53 and a limitMaturity.
BAM.PR.H OpRet 26,125 Nesbitt bought 20,000 from anonymous at 24.70. Now with a pre-tax bid-YTW of 6.43% based on a bid of 24.70 and a softMaturity 2012-3-30 at 25.00. Compare with BAM.PR.I (6.42% to 2013-12-30), BAM.PR.J (6.38% to 2018-3-30) and BAM.PR.O (7.40% to 2013-6-30).
POW.PR.D PerpetualDiscount 22,920 CIBC crossed 12,000 at 20.50. Now with a pre-tax bid-YTW of 6.23% based on a bid of 20.37 and a limitMaturity.
BMO.PR.J PerpetualDiscount 19,750 Now with a pre-tax bid-YTW of 6.05% based on a bid of 18.70 and a limitMaturity.

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

2 Responses to “August 20, 2008”

  1. prefhound says:

    “the credit crisis has destroyed the idea that unregulated financial markets always efficiently channel savings to the most promising investment projects”.

    The fallacy here is that this sentence should say that REGULATED financial markets don’t efficiently allocate capital. The banks gamed the regulatory system and lost big time.

    Once you understand that regulation vs unregulation is really not relevant to the credit crisis, then calls for MORE regulation seem “logically fallacious”.

  2. jiHymas says:

    I’ll point out that UNREGULATED financial markets don’t efficiently allocate capital either … that idea was destroyed with Overend & Gurney in 1866. I am confident that it is only my unfamiliarity with medieval finance that prevents me from citing earlier examples … didn’t a lot of people go broke lending to kings?

    Basically, it’s bad news to fund excessively long term assets with excessively short term liabilities – especially when they’re lousy assets! Nothing new there … happens at least once per generation.

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