|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|
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.
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.
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.
|Subject||RE: Other series?|
|Entry||02/24/2009 01:27 PM|
We only really looked at 3 of the series ("C F", "C W" and "C V") -- we did not look at "C Z". Both the F and W series specifically state that they are senior in priority to both the preferred and the common, while the V specifically states that it is pari passu. You should check the language in the Prospectus to be sure on the Zs.
|Subject||RE: Deferral of interest|
|Entry||02/24/2009 01:38 PM|
Your reading of the Prospectus is correct and we also believe that the current price already discounts some deferral of interest payments. That is why we believe this trade is currently so asymmetric. We believe the "likely" downside case is the expected deferral of interest (which is already priced in). Of course, the "worst case" would entail a conversion to common or a complete wipe out -- and despite the arguments we've laid out, you cannot completely rule anything out when dealing with the government and in a crisis of this magnitude). A recent precedent (although we would dispute its comparability) can be found in yesterday's announcement by BBX that it is deferring interest onf its TruPS (ticker BBXT) for up to 5 years and the securities dropped to $2.75 ($25 face value, 8.5% interest) from its Friday close of $4.96. The key difference of course is that BBX is a Florida based bank with only $450 million in book equity, so 1) it is not "too big to fail", and 2) it has a significantly worse loan portfolio than Citibank's more diversified book.
|Subject||RE: RE: Deferral of interest|
|Entry||02/25/2009 03:13 PM|
What are your thoughts about the Fed's supervisory letter released yesterday? http://www.federalreserve.gov/boarddocs/srletters/2009/SR0904.htm
"Crucial to any capital plan are the effects on a [bank holding company’s] financial condition of the payment of dividends on common stock and preferred stock, as well as dividends or interest on trust preferred securities and other tier 1 capital instruments, in cash or other value (collectively, “dividends”).
. . .
While many organizations place great importance on maintaining their dividends, a board of directors should reduce or eliminate dividends when the quantity and quality of the BHC’s earnings have declined or the BHC is experiencing other financial problems, or when the macroeconomic outlook for the BHC’s primary profit centers has deteriorated. As a general matter, the board of directors of a BHC should eliminate, defer, or severely limit the BHC’s dividends if:
(1) The BHC’s net income available to shareholders for the past four quarters, net of dividends previously paid during that period, is not sufficient to fully fund the dividends;
(2) The BHC’s prospective rate of earnings retention is not consistent with the BHC’s capital needs and overall current and prospective financial condition; or
(3) The BHC will not meet, or is in danger of not meeting, its minimum regulatory capital adequacy ratios.
Failure to do so could result in a supervisory finding that the organization is operating in an unsafe and unsound manner.
Moreover, a BHC should inform the Federal Reserve reasonably in advance of declaring or paying a dividend that exceeds earnings for the period (e.g., quarter) for which the dividend is being paid or that could result in a material adverse change to the organization’s capital structure. Declaring or paying a dividend in either circumstance could raise supervisory concerns.
. . .
While not expressly prohibited, BHCs are discouraged from using proceeds of the CPP or other public investment to pay dividends on trust preferred securities or repay debt obligations. If the financial condition of a CPP or other program participant deteriorates significantly, it may be appropriate for that BHC to cease paying dividends on the investment, as well as on trust preferred securities. "
|Entry||02/26/2009 08:24 PM|
Just a comment, the discount to face is quite interesting. If you believe the TRUPs are going to be as respected as bonds they're probably worth between 12.50-25.00. However, regarding dividends, if we want to be conservative I'd place the probability of dividend suspension at no less than 100%. This is a quasi-bankruptcy. Divvies on TRUPs, pfd or common? only the government deserves them. Will PIMCO-managed funds experience un unbearable asset-liability mismatch if the dividend goes...?
|Entry||02/27/2009 08:28 AM|
It's not clear to me if we're going to get converted into common here, the press release makes the fate of the existing TRUPS confusing: "The non-U.S. government exchange will accommodate all preferred stock holders other than trust preferred holders."
Which is followed by: "Depending upon the participation rate in the exchange, holders of Trust Preferred Securities (TruPs) and Enhanced Trust Preferred Securities (ETruPs) may also be eligible to participate."
So I dont know if we're going to be converted into toilet paper, er, common stock. Am I reading this right, are they actually suggesting that TRUPS holders would want to convert voluntarily???? Utterly insane if that's the case. They're saying that distributions for enhanced TRUPS on shares not exchanged will keep remain unchanged though. Anyone else have thoughts?
|Subject||Why does anyone think the gov't being jr...|
|Entry||02/27/2009 09:08 AM|
Why does anyone think the gov't being junior protects the senior? All that has to happen is the gov't wipes out the equity, preferreds, and TruPS with $1 of new injection above the TruPS and they still have their whole stake in "new" equity. They don't lose anything, even if they wipe themselves out because they'd still own 100% of the equity. Am I missing something? I don't see the TruPS protection that everyone talks about. Not saying it won't be a great investment, but it seems to me the risk of gov't wipeout is substantially higher than most people are assuming.
|Subject||Potential Arb Situation?|
|Entry||02/27/2009 11:06 AM|
Based on my reading, seems like it may be an interesting arb situation if $25 face value gets converted @ $3.25/share gives 7.7 shares, which can be shorted for ~$13 in value versus the pfd now at ~$9, a ~30-40% arb spread. Devil will be in the details, which is lacking at this point.
|Subject||RE: RE: Potential Arb Situation?|
|Entry||02/27/2009 11:57 AM|
Isn't there an arb in the regular prefers (series E, F and T for example)? Aren't they guaranteed to get 7.7 shares of C common per preferred share or $12.30 at $1.60 Citi common price? They are trading at around $8. What am I missing?
|Subject||RE: RE: RE: RE: Potential Arb Situation?|
|Entry||02/27/2009 12:48 PM|
I agree on the wording, but how legally can private preferred shareholders get better terms than the public preferred shareholders? Public preferreds are the same class. What entitles private holders to a better exchange ratio?
|Subject||RE: RE: RE: RE: RE: Potential Arb Situation?|
|Entry||02/27/2009 05:27 PM|
There is nothing illegal about offering different ratios to different pari passu securities. It's a voluntary exchange. The company can offer any number of shares it wants to a particular series of preferred, and holders of the series can choose to decline the offer and keep what they have. Of course, since the company is ceasing to pay dividends on the non-cumulative preferreds, those preferred holders will probably take whatever is offered. There is no "most favored nations" clause in the terms of the public preferred stock that would entitle them to a different exchange ratio. Pari passu ranking in a liquidation does not entitle the public preferreds to equal treatment in an exchange.