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17 years experience with US, European and Asian banks and finance businesses
  • The new USB PRAs: Ugly duckling or swan? 0 comments
    Jun 18, 2010 9:34 AM | about stocks: USB
    US Bancorp (NYSE:USB) last week closed an exchange offer on a convoluted capital instrument called an "Normal ITS". This was created in 2006 as part of a burst of innovative capital securities thought up by Wall Street firms - Normal ITS was a service mark of the now-defunct Wachovia Securities.  

    Such capital instruments almost always disappointed either the bank or the investors (or sometimes both), as few performed as planned once the credit crunch arrived.   One example:  USB's ITSs have a remarketing feature requiring the bank, in April 2011 and repeatedly thereafter, to auction the preferred stock that underlies the ITSs. The remarketing dividend rate has caps that are too low for the current market, so it seems unlikely that the remarketing will go well.  Also, from USB's point of view, the ITSs don't help with capital ratios that currently matter to investors or regulators.  The ITSs are currently counted as debt on USB's books, but the preferred stock would be part of the bank's equity capital.

    Trading started last Friday on the NYSE, under the symbol USB PRA. (Given the nonstandardized notation for preferred stock symbols, you may see also this as USB-A, USBA, USB.prA, or USB.PRA, depending on your information source.) USB offered noteholders an immediate exchange into depositary shares of USB preferred stock, but with a dividend of 7.189% until the end of the remarketing period (some time between April 2011 and April 2012). The new instruments are depositary shares for conventional preferred stock that rank at parity to the existing USB PRH and PRL preferred stock. Each represents a $1,000 liquidation preference.

    However, one can buy the PRAs at a discount to the most comparable preferred stock, USB PRHs, which are pari-passu and which bear a coupon rate of Libor +.60%, floored, just like the PRAs, at 3.5%.  The PRAs' voting rights and other legal matters have been amended to match those on the other USB preferred series.  The only material difference is that each of the PRAs' depositary shares has a liquidation preference of $1000, rather than the $25 that each of USB's existing preferreds bear.  However, the USB PRHs closed on Friday at exactly $20.00 - 80% of liquidation preference - whereas the USB PRA's closing midmarket price was 73% of par, even though it bears a higher coupon.

    How should the USB PRAs be valued?   Until the remarketing date (no earlier than April 2011, no later than April 2012) the PRAs will bear a 7.189% coupon and during that time, since LIBOR is likely to stay low, the PRHs can be expected to pay 3.5%. Once 3 month LIBOR rises above 2.48%, the PRAs dividend will exceed the 3.5% floor and pay 1.02% over LIBOR.  Once the PRHs rate rises over its floor, the difference in the dividend on the two preferreds is equal to 0.42%.  So the value of the difference in dividends is equal to PV of the spread shown in the table below:  
     
     
    Period
    Period
    Number
    USB PRA
    USB PRH
    Dividend
    Start
    End
    of Dividends
    Dividend
    Dividend
    Difference
    Present
    Jul-11
    4
    7.189%
    3.500%
    3.689%
    Oct-11
    Oct-12
    5
    3.500%
    3.500%
    0.000%
    Jan-13
    Jan-13
    1
    3.688%
    3.500%
    0.188%
    Apr-13
    Apr-13
    1
    3.900%
    3.500%
    0.400%
    Jul-13
    Thereafter
      Perpetuity
    4.115%
    3.695%
    0.420%
     
      
    While USB can call the preferred at any time after April 201, they are most unlikely to do so unless they can replace them with other preferreds at a dividend rate of less than LIBOR +1.02%. Even the most conservative assumptions suggest that the USB PRAs should trade at a 7% premium to the PRHs, not at a discount.   If the remarketing period extends until June 2012, the PRAs should trade at an 10.5% premium.

    If you own USB PRHs, you may prefer to sell them and move into the new PRAs - or if you have no position and want a riskless trade, one can buy the PRAs and sell short the PRHs and, at current rates, your cost of stock borrow will be much less than your added income. 



    Disclosure: Disclosure: Long PRAs and short PRHs
    Themes: Preferred Stock Stocks: USB
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