MarkTwain

On Banks: Krugman vs. Krugman

I would agree that it's dangerous to follow the advice of economists as practical trading strategy. They operate in a different world from reality (like Plato's cave, they see images of what should be projected as shadows and disregard actual reality). Frankly if economists were so plugged into reality, why wouldn't they have been raising red flags sooner? Weather forecasting is a more exact science.

The 'Preferred' Way to Play Financials

Well, PGF is now nearly $14. Did anyone take my advice? If you did at the bottom, you have nearly a triple in about 2 months.

Bring in the Antitrust Division (on Banking)

While I agree that the concentration of the banking system is a valid area for further consideration (although our system is far less concentrated than most European countries or Canada where banks have been managed well), I disagree with your overall implication that it is unAmerican as a healthy bank to announce you are healthy and intend to repay TARP asap.

Due to circumstances that no one could avoid -- Paulson's need to destigmatize TARP 1 and Obama's need to stigmatize the bankers to avoid popular revolt -- the TARP program was in retrospect a classic case of "bait and switch." The new administration has changed the terms to such an extent that there is clear adverse selection for TARP recipients. To hold the healthier banks "captive" within TARP, is just unfair and in the longer term will only make taxpayers less well off and more pissed off. Better to let those who can stand on their own return the TARP funds and focus the efforts on the weaker banks. That's an approach that the taxpayer can understand!

The 'Preferred' Way to Play Financials

Well, PGF is up from 5 and change to nearly 11, so it's time to rotate into the common.

The Geithner Plan FAQ

User 382148

The plan was just announced but there is a 5 page white paper on the Treasury site. I would keep an eye on PIMCO who will almost certainly be one of the 5managers chosen to administer the loan purchase scheme. I would expect that they may eventually offer a product for retail investors. However, I wouldn't count on it for at least 6-12 months as the mechanism gets running. This is going to be an opportunity for at least 3 years so don't worry about getting in at the ground floor.

The whole point is to create a "fire break" so that the economic panic wildfire doesn't continue to spread. The fire will continue to burn for quite some time.

The Geithner Plan FAQ

There are 4 fundamental reasons that private investors have not purchased these investments yet. First, the macro and market pictures are so cloudy and full of uncertainty that no one can effectively price risk. To the extent that a plan reduces uncertainty, it creates a positive feedback effect upon the willingness of private investors to take risk. And that in itself makes the macro and market picture less cloudy.

Next, there has been no leverage available to purchase these assets. You can't just buy a mortgage at 70% of par and hold it for 25 years and generate the type of risk-adjusted returns that investors need today. Leverage, particularly non-recourse leverage such as what the government is providing, is necessary to goose the returns.

Third, the banks have not been forced to sell. But you can see the proposed bonus tax as an unintentionally clever way of increasing the pain on the banks to the extent that faced with a choice of selling assets and exiting TARP so they can pay themselves well or bulling it out for 10 more years, they'll sell.

Finally, the hedge funds themselves have been suffering massive withdrawals and have been in no position to commit capital. However, this type of "one way" bet will be seen as too good to miss. Billionaires like Leon Black generated their wealth by picking up the pieces of previous boom/bust cycles.

John Hussman: Are Stocks Really Undervalued?

I like John but I think he's on the wrong track. Here's a letter I sent to him earlier this week:

Dear Mr. Hussman,

As an investor in your funds, I follow your weekly market comment with great interest. I have noted your continuing concern about the failure to restructure (as opposed to merely recapitalize) the banking system by imposing losses on bondholders. You have also emphasized the need for clarity (and effectively ringfencing) the troubled assets whose value is unknowable at present.

While I agree with the second point (as does everyone), I actually think your proposal to restructure the banking system would do more to destabilize the financial system than anything else we could do at present.

These bonds and preferred shares are held by investors who have shown a willingness in the past to commit capital to banks. By imposing major losses on them, you first impair their financial health, spreading the financial contagion further through the system, and, second, you destroy their appetite to invest in banks again. Worst of all, you will trigger a massive sell off in the senior securities of all financial institutions as it becomes clear the government is prepared to take advantage of the current panic to wipe out bondholders and preference holders. Just compare the value destruction after Fannie Mae wiped out preference holders with the value creation based on the generous treatment of Citigroup’s preferred stock holders.

So then the Treasury needs to shore up the insurance companies, other banks, state governments, pension plans as well as individuals whose sudden loss of value triggers another set of dominos. In today’s market, we need all the value creation we can get: “give me a lever and I will move the world” should be the operative principle.

Generally, I find your advice and commentary very practical and rooted in reality but in this case the last thing we need is to destabilize an entire class of financial instruments through radical restructuring.

High Yielding Preferred Stocks Could Also Get the Dividend Ax

Again, I haven't looked into BTZ fully but it's a blind pool with multiple layers of capital and using options. Sounds like exactly the sort of complex asset has been so hard to value. Transparency is king in today's market.

Another point that I've been trying to make is that between the UK Government and the US government, you have two very strong guarantors of the issuers underlying PGF. There are no other companies, including GE, where their survival is effectively guaranteed by sovereign governments. That doesn't mean you can get restructured away but now is precisely the time when the government is trying to attract capital into public/private partnerships. Not a good idea to try that and then wipe out those who provided capital to the banks already: "this time we promise we really won't hurt you....really....no really....."

High Yielding Preferred Stocks Could Also Get the Dividend Ax

sorry, here's the excerpt I mentioned:

NEW YORK--(Business Wire)--
Fitch Ratings has affirmed BlackRock Preferred and Equity
Advantage Trust's auction-rate preferred stock series T7, W7, R7, and
F7 at 'AAA'. The preferred stock totals $231,000,000. The rating
affirmation follows redemption of 9,240 shares of the above mentioned
series in the total amount of $231,000,000, or 50% of the total amount
of preferred shares outstanding. The 'AAA' rating denotes expectations
of very low credit risk.

The trust intends to change its primary method of leverage from
preferred shares to a combination of preferred shares reverse
repurchase transactions. A proportionate amount of each series of the
trust's auction-rate preferred shares is expected to be redeemed on or
after June 9, 2008.

BlackRock Preferred and Equity Advantage Trust is a
non-diversified, closed-end management investment company, whose
common shares are traded on the NYSE under the symbol 'BTZ'. Organized
on Dec. 27, 2006, the trust had approximately $1.3 billion in assets
under management as of April 25, 2008.

The trust's investment objective is to provide current income,
current gains and capital appreciation. The trust invests majority of
its assets in preferred and equity securities and derivatives with
economic characteristics similar to of equity securities. The trust
may invest up to 35% of its assets in non-U.S. securities and up to
20% of its assets in securities other than preferred and equity. The
trust also seeks to achieve its investment objective by employing
option in an attempt to generate gains from option premiums.

The affirmed rating is based on the strength of the trust's
underlying portfolio that provides preferred stock liquidation
coverage as well as the quality and experience of the trust's
investment advisor. At the time of the rating affirmation, the trust's
pro-forma preferred stock coverage ratios that take the above named
redemption into effect, calculated in accordance with the requirements
of the 1940 Act as amended and the Fitch coverage ratio satisfied
regulatory requirements mandating an asset coverage ratio of at least
200% as well as Fitch's minimum coverage ratio requirements of at
least 100%.

BlackRock Advisors, LLC is the trust's investment advisor.
BlackRock Financial Management, Inc., a wholly owned subsidiary of
BlackRock, Inc., serves as a sub-advisor to the trusts. BlackRock Inc.
and its affiliates had approximately $1.364 billion in assets under
management as of March 31, 2008.

Fitch's rating definitions and the terms of use of such ratings
are available on the agency's public site, fitchratings.com.
Published ratings, criteria and methodologies are available from this
site, at all times. Fitch's code of conduct, confidentiality,
conflicts of interest, affiliate firewall, compliance and other
relevant policies and procedures are also available from the 'Code of
Conduct' section of this site.

High Yielding Preferred Stocks Could Also Get the Dividend Ax

I don't have the time to investigate in detail but, looking at BTZ, my guess from the following excerpt would be there are several factors:

complexity -- this is a highly complicated, split level trust which does not seem to have much disclosure of the underlying assets. It uses options and apparently issues auction rate preferred. By contrast, PGF is an index which is rebalanced monthly with the values of the underlying assets available minute by minute by public quotes.

concentration - PGF is completely concentrated in preferred of relatively few financial institutions.

In summary, PGF is just a purer play.

Having said that, I have no idea whether BTZ is a better buy or not. It's too complicated to actually analyze it, at least given my simple brain.

Gentlemen Prefer Bland: Mortgages, Securitizations, and … Bank Capital?

This is an excellent article and the regression analysis is particularly noteworthy. The explanation for the shift in correlations from bonds to equity is of course that the preferred (which has bond-like elements and equity-like elements) started to reflect the fact that the weakening credit position of the banks pushed it down the capital structure in economic terms into simply a senior form of equity with no contractual protections other than an obligation to repay (dividends can always be deferred or foregone). This same effect occurred with junk bonds which are now senior equity.

The government certainly could have taken a different stance with the preferred holders in Fannie/Freddie but it would have represented a value transfer from taxpayers to the preferred holders. The government did take a different approach with Citigroup and the preferreds traded up from I think around 20% of par to 80%. However, note that there was little immediate impact on PGF which leads me to question your thesis that the government's action on Fannie/Freddie is what has caused prices within PGF to plunge.

I would argue, based on the analysis above, that the preferreds have plunged because they are simply senior equity and when the junior equity (ie common) is trading at nearly nothing, you can't expect the senior equity to be worth that much more.

Try regressing the common equity against the preferred equity for the top 10 banks over the past 2 months. I haven't done this but I would expect very high correlation even though the Citigroup approach yields new information on how the goverment will treat preferred stock.

High Yielding Preferred Stocks Could Also Get the Dividend Ax

By the way, I posted the following on March 3rd elsewhere on this site:

I've been buying PGF over the past month. My rationale is as follows:

- governments will not let the components of the WHPS index fail - that doesn't mean they might not punish the preferred but it's unlikely given the need to attract private capital (this is not a French style nationalization for the long-term and screwing the shareholders a la Paulson is no longer seen as smart)

- my quick review of the portfolio (remember to look at the Powershares site for the latest composition as for instance Schwab's summary is way out of date) indicates that only around 17% of the portfolio is at risk of a government intervention (this is a big assumption based on the cushion of common equity value below the preferred)

- this means that you might lose part of the 17% (but with Citigroup you actually should have ended up with more given the deal proposed) but in return you are getting a 20% tax-advantage cash yield (caveat that the yield will decline as the weaker preferreds get washed out)

- the real risk is my mind is a deferral of the preferred dividends even by some of the healthier groups. I judge this as unlikely unless the banks' situations are even worse than feared since it would again making raising private capital problematic. But if it does happen it will clearly impair the pricing although in the longer term dividends will be restored and there will be a recovery in value. I have not investigated whether the larger components have cumulative preferreds in which case you won't lose the dividend, just have it delayed. It's possible also that mergers would occur which would be likely to result in a payment at par.

So for someone who is able to take a 3 year view, I think this looks like a great investment: if I assume buying at 33% of par, holding for 7 years and receiving a 20% yield on purchase price and return of principal, I get a 7 year IRR of 32%. If I assume 33% of par, hold for 7 years, and yield of 10% (whack half of the dividends) and assume I get 70% of par, the IRR is 19%, both of these tax-advantaged. So clearly there is panic built into the pricing of these securities. Or I'm missing something....Armaggedo...

And if my hypothesis is correct, then there should be a major uplift as several factors converge:

- confidence about which banks are healthy is established through the stress tests
- the governments (RBS, Citigroup) continue to protect preferred shareholders
- risk premia decline from the completely manic levels of today and investors focus on the longer term instead of using a 2 year discount period
- there is more transparency on this ETF (as I said I think there is misinformation in what is actually in the ETF as it gets rebalanced every month

High Yielding Preferred Stocks Could Also Get the Dividend Ax

Well, I recommended PGF to some colleagues earlier this week and it's up 45% today. Of course, it's also down by huge amounts depending on when you bought it.

I think if you can get a 30% yield tax-advantaged which is where it was earlier this week, there is a margin of error that is attractive. Of course there are risks and assumptions -- for that yield, equivalent to 40% pre-tax cash pay for a high income taxpayer, there'd have to be.

I've written elsewhere about this but two key insights:

- the banks in the index will not be allowed to fail. Contrast that to high yield bonds where the credit risk is effectively unknown.

- the government cannot afford to wash out the preferred because they would never attract private capital back into the banks. It's like the cat eating a mouse and telling its brother mice that they should come for lunch too. As pointed out above, the Citigroup preferred got treated much better than market in the recap.

Yes, if the banking system truly is insolvent and yes if the government ends up owning all the banks in the ETF, then you'll be wiped. But imagine what will happen to other asset prices under such a bad scenario.

High Yielding Preferred Stocks Could Also Get the Dividend Ax

If you go to the Powershares site, they will give you a list of the components, which change month to month. You'll see that some of the troubled banks have dropped out of the WHPS index and are no longer included in PGF. You can also calculate the exposure to RBS, which I would not call a "high concentration."

Not sure where the author got the 13.6% yield. It's more like 25% and tax advantaged.

Profit from Obama's TARP 2 with Preferred ETFs

I agree with your analysis. I think the fall in the preferred has as much to do with fear as anything else. I looked at the PGX vs PGF and found that the overlap of financials was so great that it made more sense to hold PGF since you got paid much more. It's definitely speculative but I've set out my investment hypothesis in another post and so far it's been borne out by events. I think people underestimate just how important the choice of treatment of C pfds is in terms of getting comfort that preferred stock will not be expropriated.