All are humbled and floored by the backside of the boom. We are now told that gentlemen – and ladies – should prefer bland.
We should prefer bland:
- Fully amortizing fixed rate rather than interest-only neg am ARMs;
- Full documentation rather than stated aspirations;
- Conforming vanilla rather than a spicy subprime jumbo;
- 20% down rather than a fling and a prayer; and
- Unencumbered first liens rather than the deceitful silence of seconds.
Securitizations and Credit Enhancement
- Government guaranteed or backstopped Ginnies, Fannies (FNM), and Freddies (FRE) rather than private label issues with accounts spread wide;
- Simple pass-throughs rather than multi-class Collaterally Damaged Securities;
- Committed issuer “skin-in-the game” rather than casually flippant gain-on-sale; and
- A plain understanding of the underlying risk, rather than an issuer-funded alphabet jungle.
Bank Business Models and Capital Structure
- Transparently vertical businesses rather than an opaque horizontal sprawl;
- Old-school “rules-of-thumb” rather than a toothy Basel concoction; and
- Simple common rather than a bubbling brew of cumulative, convertible, putable, or participating preferreds.
The most destructive of the above is the last – a recently acquired DIStaste for preferred stock, and the corrosive reliance upon common.
It is destructive because it:
- Diverts our attention away from those who twice-lanced bank capital structures – first in September of ‘08; and again in March of ’09; and
- Completely disincents private investors from reviving the wounded banking beast, which will now be bled dry.
We will now examine “preferred stock” in much greater detail, by:
- Defining preferred stock;
- Describing how federal agencies blessed banks’ swelling use of preferred. This allowed preferred to grow from nothing to almost half of all bank capital; and
- Conducting an “event study” of preferred’s trading price and yield, as federal bailouts destroyed the private preferred stock market and any hope for a revitalized privately-owned banking industry.
Let’s begin with a definition. “Preferred Stock” is:
- Capital stock that provides a specific dividend that is paid before any dividends are paid to common stock holders. It takes precedence over common stock in the event of liquidation.
- Preferred stocks represent partial ownership in a company, but preferred stock shareholders do not enjoy any of the common stockholders’ voting rights.
- Preferred stocks pay a non-fluctuating fixed dividend, although the company may not pay this if it lacks the financial ability to do so.
- Preferred shareholders always receive their dividends first and, in bankruptcy, preferred shareholders are paid off before common stockholders.
Bank Use Of Preferred Stock
Now let’s look at regulators’ attitudes toward banks’ use of preferred stock as capital.
- Banking regulators started focusing on the low level of “Tangible Common Equity” [TCE] at large banks ... after Tim Geithner became Treasury Secretary.
- Adequacy of TCE is measured by the TCE ratio, which is the amount of TCE divided by amount of tangible assets. Better-capitalized banks have higher TCE ratios and have lower risk of failure than banks with lower ratios.
- TCE is different than common equity because TCE is reduced by the amount of a bank’s intangible assets.
- Intangible assets are things like goodwill [at one time the byproduct of federally approved bank mergers] and tax benefits from net operating loss carry forwards. These assets don’t produce income and don’t have a cash equivalent value. Moreover, intangible assets can’t support banking operations or cover losses.
- Even worse, intangible assets have a child-like “pretend” quality to them; one minute everyone pretends intangible assets are there and then the next minute reality sets in and they disappear.
The following table takes a look, over time, at the composition of banks’ capital structure. It is based on the capital structure of nine large US banks.
Mark Sunshine graciously provided me with the bank capital data that I used to create Figure 1. Thank you, Mark, and your helpful investment bank friends. As Mark has noted on his website – Sunshine Notes - the list of banks doesn’t claim to be a scientific or random sample.
Figure 1: Tangible Equity, Tangible Common, and Preferred Stock, 1995 and 2008. Source: SNL Financial, author’s calculations.
We see from Figure 1 that:
- Between 1995 and 2008, the tangible equity/tangible asset ratio of the sampled banks was relatively unchanged, dropping slightly from 6.4% to 5.4%.
- This modest decline in the “tangible equity” ratio masked a much larger decline in the tangible common equity/tangible asset ratio, which plunged from 6.3% to 2.7%.
- This dive in the “tangible common equity” ratio reflected a surge in the sampled banks’ use of preferred stock.
- In 1995, preferred stock represented a negligible amount of the banks’ capital structure.
- By 2008, however, just before Secretary Geithner became Treasury Secretary, and regulators “started focusing on the low level of TCE”, preferred stock represented virtually half of the sampled banks’ capital.
Given the reliance upon preferred by 2008, it’s clear that regulators’ sudden distaste for preferred (which is excluded - by definition - from TCE) is a significant policy change.
It is at least as significant as, and resembles, regulators’ repudiation of supervisory goodwill during the S&L crisis of the 1980’s, which produced waves of S&L failures.
Supervisory goodwill was an intangible asset created when sound S&L’s acquired, and paid more than book value for, failing institutions. These transactions were instigated and blessed by the government – in much the same way that Bank of America acquired Merrill Lynch in 2008.
At the conclusion of the S&L debacle, the former FDIC Chairman said:
I made a commitment . . . and the government breached it and I find that very offensive . . .
I made a promise . . . that we would count goodwill as part of capital for [many] … years, amortized on a straight-line basis. It was a very conscious decision on our part… I don’t think anyone after me had the right to turn their backs on that.
If you can’t count on the government to live up to its word, then the FDIC is never going to be able to do business with people in the future.
Source: William Isaac, Former Chairman FDIC , Source: MeritorPSFS.com
Note: For additional background on supervisory goodwill, and the similarities between today’s crisis and the S&L crisis, see my “Thing One & Thing Two – Supervisory Goodwill and TARP” of 19 Jan 2009.
It should be emphasized that US banking regulators had not objected to (and had encouraged) banks’ increased use of preferred stock as capital.
The Basel II international bank capital standards blessed preferred stock, and a variety of US banking and thrift agencies helped construct the Basel rules. These included the:
- Board of Governors of the Federal Reserve System;
- Federal Deposit Insurance Corporation;
- Office of the Comptroller of the Currency, and
- Office of Thrift Supervision.
The federally blessed rules, which had been in the works for many years, finally took effect in April of 2008.
Let’s now turn our attention to a readily accessible measure of financial preferred stock performance, so that we can tie the destruction of the preferred market to government “bailout” activity.
Our Benchmark - Financial Preferred ETF (NYSEARCA:PGF)
Rather than focus upon the preferred stock of any particular financial firm, we’ll look at the performance of a representative basket of preferred stocks. Specifically, the performance of an exchange-traded-fund (or ETF) that invests in preferred stocks issued by financial firms.
That ETF is the Powershares Financial Preferred Portfolio with symbol PGF. Websites began to track it in early 2007, about 6 months before the subprime unpleasantness began. Note: I do NOT own any shares of PGF.
Below is a snapshot of the “top 10” PGF holdings (i.e., roughly one-third) at year-end 2008:
Figure 2: PGF Top 10 Holdings, Year End 2008. Source: Invescopowershares.com
The “coupon” in Figure 2 refers to the “non-fluctuating fixed dividend” referenced above. Dividend yields of the year-end ’08 “Top 10” holdings were in the 8% range, when the preferred stocks in the ETF were originally issued [more about historical and current yields below!].
PGF Price History and Relationships
Below is a quick recap of PGF’s weekly trading price, since January 2007:
Figure 3: PGF share price since January 2007. Source: Yahoo! Finance.
As the chart indicates, PGF’s price was virtually unchanged for the first half of 2007, and lost less than $3 by mid-October 2007 – three months after jumbo mortgage products spreads blew out in July.
As the following charts (see Figure 4, below) indicate, PGF’s price movements, in the first half of 2007, were more closely related to bond prices than they were to those of financial stocks. During this period, preferred stock was a relatively cheap form of bank capital, with costs – and coupons – similar to “straight debt.”
Figure 4: PGF Price Scatterplots, Jan 2007 – June 2007.
Top – Scatterplot of PGF and Financial Stock Prices (NYSEARCA:XLF)
Bottom – Scatterplot of PGF and Corporate Bond Prices (NYSEARCA:LQD)
Data: Yahoo! Finance. Note: Prices adjusted to reflect dividend distributions. [Yahoo! is source for all subsequent data.]
As the top chart in Figure 4 indicates, there was NO relation between the price of PGF and financial stocks (measured by the XLF Financial SPDR) in early ‘07. Indeed, the bottom chart (which plots PGF prices against those of the corporate bond ETF, LQD), indicates that PGF prices tended to track those of corporate bond prices in the first half of ‘07.
These relationships broke down in the summer of 2007, when the non-conforming mortgage market collapsed.
Preferred stock prices began to more closely follow the prices of financial STOCKS (See Figure 5), rather than the prices of corporate, coupon-paying BONDS (bond chart NOT shown).
Figure 5: PGF Price Scatterplot, July 2007 – Dec 2007.
Scatterplot of PGF and Financial Stock Prices ((XLF))
PGF Yield History and Relationships
Figure 6: PGF Yield, January 2007 – March 2009.
PGF’s yield continued to rise as 2007 ended, but did not move up that sharply when JPMorgan (NYSE:JPM) acquired Bear in the spring of 2008. This is because JPMorgan converted Bear ‘s outstanding preferred into “substantially identical” JPMorgan obligations, and preferred investors were relatively unaffected.
GSE Conservatorship – September 2008
This was not the case when Fannie and Freddie (the “GSE’s”) were placed into conservatorship in early Sep 2008 [See Figure 6, above].
Government investments in the GSE’s came in the form of a new class of government-owned preferred stock that extinguished the value of the existing GSE preferreds. This created unanticipated problems for other banks that had invested in the GSE preferreds:
When the FHFA placed Fannie and Freddie in conservatorship, the payment of dividends on preferred stock was eliminated. At the time, federal banking regulators estimated that only a few dozen banks would be affected.
However, the ABA survey shows that the number of banks affected is considerably larger.
The negative impact on banks ... is far greater than the regulators first thought,’ [the ABA] said...
Source: Tim McLaughlin, Boston Business Journal, Mass. banks hit hardest by Fannie, Freddie preferred, 23 Sep 2008 [emphasis added].
GSE conservatorship had an immediate and continuing impact upon bank capital positions.
Bloomberg described the immediate impact on 8 Sep 2008:
While the preferreds aren't being formally wiped out, their value is largely gone,” ... analyst Sean Ryan said yesterday. The takeover has “pretty ugly implications for capital adequacy” for some lenders, he said.
Some smaller lenders that bought preferred stock ...have holdings valued at a significant percentage of their capital. Banks that don't maintain minimum capital levels against losses may ... in some cases be shut down.
Source: Linda Shen, Bloomberg - Lenders With `Outsized' GSE Stakes May Need Capital, 8 Sep 2008, [emphasis added].
The resulting rise in preferred yields prevented financial institutions from economically raising additional capital via new preferred issues. After the government boosted its equity stake in Citigroup (NYSE:C) in March 2009, Reuters reported:
[The] … decision to halt dividend payments on some of its preferred shares may be the final blow for certain bank preferred stocks and may further dry up the willingness of private investors to buy other bank securities...
A BNP Paribas analyst said that “investors will be concerned that the government may intervene in other banks... which have borrowed from TARP, and this will have a similarly negative impact on these types of preferred shares,” he said.
Standard & Poor's said in a statement that “...We are ... concerned that [this] ... could mark a tipping point for the financial institutions sector...”
...As investors take fresh losses on bank securities, financial companies are increasingly at the mercy of government programs for their funding.
Source: Karen Brettell, Reuters - Citi dividend decision watershed event, 4 Mar 2009, [emphasis added].
By 6 Mar 2009, yields on financial preferreds topped 20%. The preferred market cannot provide banks with any additional capital. As a result of “bailout” efforts, preferreds trades like, and are as expensive as, common equity.
Economists use the term “crowding out” to refer to:
- Reductions in private consumption or investment that occur because of an increase in government spending.
As typically described, government spending “crowds out”:
- Private spending if it is financed by a tax increase, which tends to reduce private consumption; or
- Private investment if it is financed by increased government borrowing, which eventually increases interest rates, and leads to a reduction in private investment.
The ’08 and ’09 “bailouts” of Fannie, Freddie and Citigroup are a new manifestation of “crowding out” unanticipated by the conventional theory.
In this instance, the government has “crowded out” and eliminated the possibility of any future private investments in financial preferreds by its destruction of the pre-existing preferred market.
Having spoiled the stream with its own, the government has the chutzpah to warn that we should not to drink the water. “Forget ‘tangible equity,’ which includes preferred stock – focus your attention upon ‘tangible common equity,’ or TCE.”
Prior to the “wipeout” of the GSE preferred in Sep 2008, James Grant of Grant’s Interest Rate Observer was asked:
- What would be the alternative to preserving the value of GSE preferreds?
- His answer – we should get down on our knees and pray.
Source: John Dizard, The Financial Times - A measured view of GSE preferreds, 31 Aug 2008.
Excuse me, Marilyn, I don’t mean to crowd - but I need to get down on the floor.