February 23, 2009 - 7:52am EST by
2009 2010
Price: 6.26 EPS N/A N/A
Shares Out. (in M): 49 P/E N/A N/A
Market Cap (in $M): 307 P/FCF N/A N/A
Net Debt (in $M): 0 EBIT 0 0

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We all know that fear and panic create market dislocations, pricing aberrations and extraordinary investment opportunities.  And we think we've found a big one.  The current chaos surrounding the fate of the private banking system - to nationalize or not - has created an extraordinary opportunity to generate outsized returns (nearly 30% current yield and potentially over 100% upside once current uncertainty is resolved) on a debt instrument that we believe also comes with very little risk. 

The Situation:

As investors speculate that the equity in the likes of Citibank and Bank of America could be wiped out, their common shares have plummeted more than 90% this year - and the preferred stock has traded similarly (not too surprising), but so have the misunderstood trust preferred securities.  And therein lies the opportunity.  While we will not speculate as to whether or not the federal government will only dilute or outright eliminate the equity of these institutions (a potentially lucrative trade for anyone with the stomach for such a binary outcome), we believe that the trust preferreds have been lumped in with the equity securities by investors that frankly don't understand why they have a fundamentally different safety profile.


What are Trust Preferreds (briefly):

Unlike stock (common or preferred), Enhanced Trust Preferred Securities (also called TruPS) are debt - specifically, the issuer sells junior subordinated debt securities to a trust that then issues shares in those securities to investors (basically a way to benefit from the positive tax attributes of debt, while also effectively getting to count the securities in their capital ratios as equity).  They pay a set interest rate and rank above both common and preferred stock in the waterfall of priority claims on assets in the event of a total collapse.  To be clear, you've got to read the fine print on these instruments - find the Prospectus and check it out closely to be sure because some of these securities do in fact seem closer in priority to preferred stock than we would be comfortable with given the current uncertainty.  Two that we are recommending are Citibank TruPS represented by the Bloomberg tickers "C W Pfd" and "C F Pfd", both of which state in their Prospectus that "the junior subordinated debt securities will rank senior to all of Citigroup's equity securities, including preferred stock."


The Return Potential:

Let's take a quick look at just what kind of return we're talking about after recent price declines.  The "C F" security is a good example, with each share representing $25.00 of face value sub debt that pays a quarterly dividend of 7.25% ($1.81).  This TruPS closed at just $6.26 on Friday, representing a yield of 29.0%.  The return on the "C W" is comparable.


The Risk:

Sticking with the "C F" issue above, the security is callable at par in August 2012 and final maturity is August 2067.  Although the bank cannot stop paying interest on it, there is a provision that allows them to postpone interest payments for 5 to 10 years.  It is not unreasonable to think that such a provision might be enacted in order to preserve capital during the current economic crisis, but it is important to note that these payments will continue to accrue and compound interest and must be repaid in full before any preferred or common shareholders ever receive any dividends again (and this includes the federal government!).  Surely, the government intends to get paid back and that's a great thing for TruPS holders since they are senior in every respect (in fact, the heads of the nation's largest 8 banks were at a Congressional hearing last week reiterating the fact that the Treasury would receive its dividends on schedule, meaning that so will holders of the TruPS).  That kind of return for that long sitting ahead of the federal government seems extremely compelling, even if investors end up having to forego these dividends initially for some period of time.


What we do not expect is that the federal government fully nationalizes the banks (Treasury statements made after the close on Friday are consistent with our belief and just last night and this morning, articles are surfacing about talks between Citibank and the government referring to an equity stake of 25-40%), including a full wipe-out of common and preferred equity and going so far as to cross the isle of the capital structure to actually impair a debt security.  The psychological impact on the markets of impairing sub debt would be extraordinary.  The TruPS at just the largest 4 banks alone represent more than $60 billion in value and additional junior sub debt securities would represent hundreds of billions more.  Just eliminating the preferred dividends at Fannie and Freddie led to widespread market dislocations, so going a serious step further into impairing debt securities through a governmental equity infusion would seem reckless at this point (post Lehman).  This issue is further supported by the fact that many US insurance companies are large holders of the TruPS, so an impairment here would create a cascading crisis.  In fact, it's more likely than not that the government puts even more money into these institutions, essentially improving the credit safety profile of the TruPS and raising their value.


The bottom line is that TruPS have traded down with preferred stock, despite the fact that they are fundamentally different securities - debt securities - senior in every way to all equity (both common and preferred) and all claims of the federal government.  With returns now approaching 30%, these are certainly some of the best risk-adjusted returns available today.


Once the status and terms of the governmental assistance are fully ironed out (which the Treasury says will be within weeks, if not sooner), we believe these securities will rebound substantially to a level between the current $6 market price and the $25 face value.

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