Avoid Banks' Common Shares; Opt for Preferreds, Minibonds

Every quarter, when looking at the financial markets, it's the same thing. We all wait with heightened anticipation as company after company releases their quarterly reports showing how much they supposedly made or lost.

And recently, it's more about the losses than the gains. This is especially true when it comes to so many of the banks around the US.

Last week I went through what I've seen coming in the banking market. The biggest banks, with their massive trading and investment operations and top tier lobbyists, have gamed the system so that they're rocking and rolling, while the smaller banks - even those with massive nationwide operations but without the trading and investment acumen and lobbyists - are feeling the pinch of the credit crunch.

And that's what we continue to see to play out as bank after bank rolls out their quarterlies.

A Two-Tiered Market for Bank Stocks

The big guys such as Goldman Sachs (GS) and JP Morgan (JPM) - with all of their tight connections over at the Fed, Treasury and 1600 Pennsylvania Avenue - are having some of their best times ever.

These banks aren't in the lending game - well not as much as their more pedestrian cousins, commercial banks.

These guys do own plenty of commercial, consumer and mortgage debt that, if brought to the markets, would be considered too toxic to handle. But because these "assets" are securitized, their owners get to assign their own values to the loans and bonds. Even better, even if the stuff isn't even current, they get to post it as collateral for all sorts of Federal loans and swaps.

Then, on top of that, they still get to borrow at or near zero interest from special facilities at the Fed and through the Treasury. Meanwhile, they also keep their FDIC credit backing for bonds issued. In turn, they just flip all of this free cash into the market - buying other credit enhanced securities - and presto: lots of spread and little risk - given that Uncle Sam has their backs.

Little is being cleaned up in these firms. And no wonder; for now, there's little incentive for any of it to actually get cleaned up.

Tougher Rules for Real Banks

Meanwhile, the banks with whole loans on their books are still in trouble.

The FDIC has actually been doing, well, some of its job recently. It's requiring banks that make - and continue to hold - direct loans to middle-market and smaller businesses, consumers and mortgages, actually bolster their loan loss provisions.

In addition, the FDIC has also hit regular commercial banks - particularly middle-market banks - with larger insurance fees to help to bolster FDIC reserves.

This is at least beginning to address the need for bad and non-performing loan clean-up. But at the same time, the result is that these banks are turning in some pretty nasty numbers this past quarter.

Taking a look at a collection of locally headquartered banks in my Saint Louis. The numbers have been bad. Enterprise Bank (EBTC), headed by one of my old comrades from Mark Twain Bank - Peter Benoist - turned in a loss.

Enterprise cited the loan loss provisions and the FDIC fees, along with costs from its use of preferred stock, as the reason for the loss.

United Missouri told pretty much the same story in terms of the cost side of its quarterly number, but it still managed a smaller profit vs the same quarter last year. And the list continues with more of the same for Pulaski and plenty of other locally-headquartered banks.

These banks are doing real banking - and, as such, they're taking the hits for doing real business in the real economy.

And on the national market, some of the big banks that lack the trading and political acumen of Goldman and JP Morgan are turning in results similar to those of their smaller comrades.

Wells Fargo (WFC), while large, has for long been up to its eyeballs in mortgage debt that has to be worked through. That's why its quarterly showed some hefty loan loss provisions. And the list continues, with US Bank (USB) and Regions Financial (RF) following a similar story line.

Economy Suffers While Politically Connected Banks Soar

As what I term "real banks" begin to dig out the sludge of their loan books, consumer and business credit is not getting done.

According to the trailing reports from the Fed, the prior quarter saw consumer credit contract by 3.5 percent - while business credit is down some 0.3 percent. I expect that both of these credit sectors will see further contraction as we get the second quarter data from the Fed.

This isn't surprising given what some banks are doing.

And to back me up, I'll cite the survey by the National Small Business Association (NSBA) of its membership. Out of thousands of businesses that make up the bulk of our economy and jobs, 80 percent say that they've been pretty much cut off from credit.

And while Goldman and JP Morgan have been popping corks and enjoying Caspian caviar thanks to Uncle Sam's largess - 75 percent of the real businesses around the nation say that Uncle Sam's "stimulus" has amounted to flat out nothing for them.

Buy Bank Preferred Shares, Minibonds; Avoid Bank Common Shares

Now, outside of perhaps the common shares of Goldman and a few others, the markets have been punishing the stocks of plenty of banks both pre- and post-release of their quarterly reports.

So, while I continue to tell you to avoid bank stocks and bank ETFs (including the short-structured ETFs) - I very much continue to recommend that you buy and own plenty of nicely high-yielding bank preferreds and bank minibonds for your retirement investing.

But why invest in banks at all?

Because as they continue to clean up and bolster their balance sheets, banks are getting even better credit risks, which means that you'll be even more likely to get paid your high-yield dividends and interest payments.

So, Regions Financial common - avoid. But do buy the Regions Financial 8.875 percent preferred (NYSE: RF.Z). The common got hit but the preferred keeps humming along. Still trading right around 21 bucks, it's a nice yielder paying you over 10 percent.

Wells Fargo's common isn't what I'd want to own - but the 7 percent preferred (NYSE: WSF) is a buy. Trading much like the Regions, the Wells Fargo preferred is now around 23 and change, resulting in a still nice quarterly pay day for you amounting to a yield of near 7.5 percent.

US Bank might be getting a break from the market with its common, but while I do still have some lingering shares from a buyout,I'm now looking at the preferred from this bank. Look at the 5.75 percent preferred (NYSE: USB.E) trading just a tick or so around 20. It's another good stock that pays you with a yield of around 7.1 percent.

On the minibond front, I continue to recommend the Goldman Sachs 5.8 percent minibond trading under the symbol of JZS on the NYSE. Trading around 19, it's a great bargain with a yield paid to you of over 7.5 percent.

And last up is Bank of America with its 5.875 percent minibond (NYSE: IKM). It keeps climbing slowly - but surely - trading now around 20, up nearly double from when I first began to make my buy call last winter. Yielding now around 7.2 percent, I rank it as a nice yielding buy.

Disclosures: Long: RF.Z, WSF, USB, JZS, IKM

Comments

[RiskTrade:]

Pointless Article. Buying pref rather then common makes little sense. Buying pref only caps your upside while really exposing you to the same risk as common. In a default pref holders and common holders both get nothing. Whats worse is that bank pref suffers from the risk of forced conversion to common. Further pref usually involves liquidity risk relative to the common. Also from a relative value perpsective it makes more sense to buy the sub debt rather then the pref.

Jul 27 07:43 AM

[southgent1951:]

There needs to be a distinction made between regular preferred and trust preferred. This is a link to my post discussing the differences:
tennesseeindependent.b...

Unless the author makes that distinction, the reader will not know whether the security is part of the bank's equity or debt. WSF, USBPRE and RFPRZ are Trust Preferred issues, a form of junior subordinated debt. It would be helpful to read the WSF prospectus: www.sec.gov

Wells Fargo forms a Delaware Trust, and buys all of the common shares. The Trust is therefore controlled by it. The Trust then purchases junior subordinated debentures from Wells Fargo which matures in 2031, and those securities have a 7% coupon. Debenture is a fancy name for debt. The Trust raises the funds to buy those junior bonds by selling "preferred" shares in the Trust to the public, which is what is traded on the stock exchange with the symbol WSF. The use of the word "preferred" in this context can be confusing unless it is clarified for the investors unfamiliar with these securities. Preferred does not mean in this context what investors understand as traditional equity preferred, which stands between common stock and all debt in the capital structure. Instead, the shares represent a preferred undivided beneficial interest in the underlying assets of the Trust, which are in this case junior bonds. So, I view WSF as a certificate that represents a beneficial and indirect interest in a bond via a Trust. I have owned WSF in the past, no longer own it, and the payments made to the shareholders are taxed as interest.

Many banks also issue equity preferred securities. Those securities are senior to common stock and junior to all forms of debt. Their distributions are classified as dividends, and will generally be considered qualified dividends. There is a site, called QuantumOnline, which is free, though registration is required, that includes the equity preferred issues under the heading "Preferreds eligible for the 15% tax rate:
://quantumonline.com

The Trust Preferred securities do have maturity dates but they are generally way into the future, which subjects the holder to the risks associated with any long term bond. Another risk is that there are liberal deferral rights for these junior bonds. Generally, as long as no payment is made to the holder of junior securities, the issuer of the junior bond may defer interest payments for up to 5 years (that is the limit in most instances), though the deferred interest does accumulate and has tax consequences if held in a taxable account.

It is my personal view that the holder of any equity preferred or trust preferred security from a bank seized by the FDIC would likely be holding a worthless piece of paper.

While I used to own in the distant past WSF, I generally have an unfavorable view of junior debt issues from banks. I will occasionally make small purchases. For Wells Fargo, I bought JWF at $9.15 on 3/6/2009: /tennesseeindependent.b... This is another Trust Preferred issue from Wells Fargo. Par value is $25 with a maturity in 2034. I would not even consider buying it at anywhere near its current price.

I also bought some KTV, which is a Trust Certificate. What I am about to say will make your head hurt some. This is different from a Trust Preferred. A Grantor Trust is created with an independent trustee and then the creator of the Trust deposits a bond issue from a single issuer into the Trust, not a bond from the creator of the Trust. The Trust has an independent Trustee. The buyer of a Trust Certificate is the beneficial owner of the underlying bond. The underlying bond might be a senior bond or a junior bond. In the case of KTV, the underlying bond is a junior bond, a Trust Preferred issue from First Union which was subsequently acquired by Wachovia. Wells recently acquired Wachovia. tennesseeindependent.b...
In that last linked post, I discuss several of the Wells Fargo Trust Preferred issues that are traded on the exchanges and compare them.

I group the mini bonds, sometimes referred to as baby bonds, Trust Certificates and Trust Preferred under the heading Exchange Traded Bonds: tennesseeindependent.b...

Jul 27 08:55 AM

[Smackdown:]

RiskTrade, you have your facts very wrong. Trust preferreds and Enhanced Trust preferreds are debt on the books and are senior to both the regular equity preferreds and the TARP. They also have cumulative dividend features. I loaded the truck up on these many months ago. I got as much as 30% yields and many have more than doubled. How is that for risk/reward??? So, I beg to differ. In addition, back then, some of the regular preferreds were trading at levels lower than the common!! Preferred was a home run buy then.

Now, I am much more selective. Less preferreds, more MLPs. The days of fish in the barrel are behind us and those that snoozed, lost out on one of the greatest money making opportunities of our lifetime.


On Jul 27 07:43 AM RiskTrade wrote:

> Pointless Article. Buying pref rather then common makes little sense.
> Buying pref only caps your upside while really exposing you to the
> same risk as common. In a default pref holders and common holders
> both get nothing. Whats worse is that bank pref suffers from the
> risk of forced conversion to common. Further pref usually involves
> liquidity risk relative to the common. Also from a relative value
> perpsective it makes more sense to buy the sub debt rather then the
> pref.

Jul 27 08:57 AM

[john s. gordon:]

author - thank you for once more making clear the distinction/difference between politically connected banks and real banks.
> jack

Jul 27 09:36 AM

[deskandchairs:]

Well, at least Neil isn't selling smoked salmon, like he was during his days at Personal Finance newsletter.

Jul 27 07:06 PM