TARP vs. Non-TARP: Investing with Uncle Sam at a 60% Discount

Under the U.S. Treasury's Capital Purchase Program ("TARP"), the federal government is investing at least $250 billion dollars in preferred shares of select financial institutions.

The terms of TARP investments are mild for these harsh economic times: The preferred shares issued to the government under the program will rank on par with existing preferred shares, and dividends will be set to yield five percent on the investment for three years, nine percent thereafter. The five percent yield is at the low-end for preferreds generally, and about half the rate in recent private market deals, notably those involving Berkshire Hathaway (BRK.A), Goldman Sachs (GS) and General Electric (GE).

The government's TARP investments are intended to improve the capital positions of participating entities and ease any liquidity concerns.

In some cases, the balance sheet effects of the TARP investments are quite dramatic. Consider Zion Bancorporation (ZION), which announced yesterday that it received preliminary approval for a $1.4B TARP investment. (Press release available at here or here.) The $1.4 from Uncle Sam compares with $287M in existing preferred equity and about $5.3B of common equity. (These figures are as of September 30, 2008 and are available here.)

With its TARP investment, the federal government in increasing Zion's total equity capital by about 25%. According to the Zion's press release, the TARP investment will increase its Tier 1 Risk Based Capital Ratio from 8.07% to about 10.90% and its Total Risk Based Capital Ratio from 12.30% to 15.13%.

Here's the potentially interesting investment angle: Zion's existing preferreds (and those of many other financial companies) continue to trade at distressed valuations. Zion's Series B preferreds are quoted at $20.75, and Series A preferreds at $9.91. Both issues have a $25 face value, and yield are about 9.6% and 10% respectively.

Barrons's commented on the seeming attractiveness on bank preferred shares in an article Sunday, citing the double-digit yields and TARP's effects on capitalization and liquidity ("Weekday Trader: Tapping Into Wall Street's Income Secret").

As a general proposition, preferred shares purchased at face value are not compelling investments. While senior to common stock, they are akin to unsecured debt, and the best an investor can hope for is the return of capital and receipt of the stated interest.

The investment perspective changes, however, as the price of the preferred falls and the potential for capital gains arises: At $10, a preferred can be a one-and-a-half bagger if it returns to face value. At $8, it's a potential three-bagger. The bottom line is that distressed preferreds are primarily a play on company solvency than company profitability, and preferred prices rise, sometimes dramatically, as solvency concerns recede. An 18-month price chart of Countrywide's (CFC) two preferred issues, or a 10-year chart of stodgy Pacific Gas & Electric's (PCG) Series A illustrates the point.

Which brings us back to TARP. The program is very much about guaranteeing solvency, and is therefore unambiguously positive for the existing preferred shares. TARP improves solvency directly by boosting balance sheet equity, and boosting it fairly dramatic fashion. And it does so indirectly by putting a Paulson "stamp of approval" on the participating institution. In the Barron's article cited above, one fund manager stated his belief that

Banks that receive significant Treasury capital can probably be considered ‘too big to fail,' and therefore a safe investment . . . Those selected companies are the foundations of the system . . and the government isn't going to let them go.

So we have a situation where the alleviation of solvency concerns is a clear priority of the federal government, where a federal program is being executed to address the concern, and where preferred share prices have not meaningfully increased to reflect these facts. The basic investment thesis is that some preferred share prices are underpriced.

Augmenting the attractiveness of preferreds now is the fact that their price performance is only secondarily driven by company profitability. Solvency is the primary concern, and the share price reflect the market's assessment of solvency. This could be critical to performance if the U.S. is in a recession now, and experiences limited profitability going forward. This will have a much smaller adverse effect on preferred shares than common shares. Further, the preferreds' higher and more certain dividend returns could also come to be increasingly valued under recessionary conditions, increasing their price relative to common.

Multiple mutual funds and ETFs focus on preferred shares, with at least one, Powershares Financial Preferred Portfolio (PGF), focusing exclusively on preferreds issued by financial companies.

Even a cursory review of the registration statements for individual preferred issues makes clear that are an idiosyncratic bunch, including cumulative, non-cumulative, convertibles, fixed-rate and variable rate issues. Couple this with low volume, and a mutual fund or ETF is perhaps the best means for executing the investment idea.

But individual issues have their individual, and potentially compelling, twists. Returning to the Zion Series A, the dividend is floating, and equals the greater of: [1] 4% or, [2] "0.520% above three-month LIBOR." While uninteresting at its $25 face value, the dividend it is equivalent to the greater of: [1] 10% or [2] 2.5 x (.52% + three month LIBOR) at the current $10 asking price. If LIBOR were to increase to 5.5%, the yield on this issue would increase to about 15% So the multiplier created by the low share price effectively offers a hedge against increasing interest rates.

The bottom line is that there are two disparate markets for preferred shares right now: One in which the government is investing billion dollar sums in preferreds at face value in exchange for an immediate 5% yield (and some stock options), and another market in which equally-senior preferreds are trading at extreme discounts to face value and offer double-digit dividend yields.

For investors who believe that TARP's beneficial effects have not yet been incorporated in preferred share prices, or who want a high-yield port in these economically stormy times, there are many compelling preferred shares, ETFs and funds, including shares where one can invest along side Uncle Sam at a 60% discount.

Disclosure: Author is long ZBPRA

Comments

[Vox Rationalis:]

The preferreds are indeed interesting - take a look at the PGF, the dividend of which has been impaired (dropping from about 0.125/month to .108), now yielding about 9.5% and priced about 27% lower than its August average, (when the yield was a bit more than 8%), and 37% less than its average from the first part of the year (when the yield was about 7%). Assuming the big banks' and insurers' preferred dividends survive (which they must, since losing those dividends are would crush their ability to raise additional capital), this fund should have a nice capital gain; if not it still provides a monthly income stream.

Of course, yesterday it lagged the overall market by more than 8%.

One quibble: don't expect 3-month LIBOR to grow at any point in the near future; expect it to shrink.

2008 Oct 29 08:26 AM

[MichaelZZ:]

"BAILOUT" PARAMETERS SHOULD BE ADJUSTED:

Paraphrasing Isaac:
Objects in motion tend to remain in motion, objects at rest tend to remain at rest, and to change either condition, requires energy.

In this case, the energy factor should be effected by Congress by legislating the appropriate fiscal adjustments, i.e., immediately (do not wait until 2010) repeal those portions of the Bush tax legislations for those with taxable incomes in excess of $200,000 (arbitrary, i.e., could be $225M, $230M) and legislate permanent tax reductions for those with taxable incomes under $80,000.

This will be the energy factor, which will prime the engine of our economy. The longer it takes to do this, the more problematic will be the results.

A one-shot stimulus package will not work, as the recipients will pay down debt or add to savings due to insecurities, whereas a permanent tax reduction will mean that they will see their net paychecks increase and will have greater confidence. Unless consumers increase their collective confidence and spend, the situation will become much graver.

The parameters of the first traunch/tranche of $125 billion should be changed:

1) Only those institutions who want the funds should receive, i.e., none should be coerced into taking

2) The dividend rate should be changed to, at least 11%, for the purpose to stimulate the institutions to attempt to raise capital from private sources. They would know that they have the backstop of the 11% preferreds.

3) The conversion factor should be significant

4) As in the case of the Buffett purchase of GS preferreds, there should be substantial long-term warrants

5) The "fund" should be given seats on the Boards.

6) All dividends, other than any preferred stock dividends should be deferred for one year and will be re-assessed at the end of the year

7) There should be a moratorium for any bonuses and this will be reevaluated at the end of the first year

8) Those institutions which do not accept the "fund's" requirements and eventually fail, and which will have exacted bonuses will place in civil and criminal jeopardy those recipients of the bonuses. The punishments will include imprisonments and the return of the bonuses plus substantial monetary penalties.

The common shareholders will be adversely affected (much of which has already been reflected), but that is appropriate.

CAPITALISM WILL BE ALIVE AND WELL.....................

Michael Z.
Sherman Oaks
[e-mail]
310-479-7480 cell phone

2008 Oct 29 08:50 AM

[sumosama:]

Good article. I need to learn a great deal more about preferreds.

2008 Oct 29 11:37 AM

[milt tomkins:]

This is a great story.I will quote from it in my thesis about hedge fund secrecy. I also learned a lot about hedge fund trading from 2 other books. Hedge Fund Trading Secrets Revealed..by Robert Dorfman..and Confessions of a Street Addict of course by Jim Cramer..written before he got really famous..both are very riveting and informative. You should check them out if you like reading behind the scenes stuff about hedge funds

2008 Oct 29 11:41 AM

[everybodys ...:]

This is well thought out and evidences basic understanding of underlying economic factors in addition to eddies in various nooks and crannies of the market. As a historian rather than an economist I cannot add to these perceptions, but I appreciate the clarity of the explanation and will forward to my financial advisor forthwith.

2008 Oct 29 12:32 PM

[Alex Filonov:]

As far as I know, government didn't guarantee Fanny Mae and Freddy Mac preferreds. Why it would be different for said banks? Let's say, bank participates in TARP, fails anyway. Government steps in, guarantees all deposits and all bonds issued by bank with exception of preferreds. Bank is solvent but common and preferreds are wiped out. Is there any clause in TARP preventing that?

2008 Oct 29 05:04 PM