Direction of Interest Rates

Why is there pressure for interest rates to go down ?
Don

The Ten Criteria That Saved Preferred Stock Investors

Prior to the start of the Global Credit Crisis in June 2007, would you have known which publicly traded financial institutions were going to go bankrupt, wiping out their preferred stock investors, versus which institutions were going to be acquired by healthier banks, saving their preferred stock investors?

Throughout 2008 daily press coverage identified publicly traded banks that were in deep trouble - New Century, Lehman Brothers, IndyMac, National City, Fannie Mae, Freddie Mac, Merrill Lynch, Countrywide, Washington Mutual, Bear Stearns, Wachovia.

Some went bankrupt, wiping out the preferred stock dividends and principle of those preferred stock investors who had invested in them; others were acquired by stronger banks, saving those investors. The preferred stocks issued by banks that were acquired prior to bankruptcy continue to pay their dividends to this day.

Here are the big publicly traded institutions that failed, wiping out their preferred stock investors: New Century, Lehman Brothers, Fannie Mae, Freddie Mac, Washington Mutual and Bear Stearns (IndyMac also busted but did not have any preferred stock issues trading).

And here are the publicly traded banks that were acquired by a healthier institution: National City (by PNC Financial), Merrill Lynch (by Bank of America), Countrywide (also by Bank of America) and Wachovia (by Wells Fargo). Those invested in the preferred stocks of these banks were saved and have received all dividends uninterrupted.

But here is the really interesting thing about these banks with respect to their preferred stocks and those who invested in them. Based on my preferred stock research, chapter 7 of my book, Preferred Stock Investing, itemizes ten specific criteria that preferred stocks must meet in order to be considered the highest quality preferred stocks available - “CDx3 Preferred Stocks.” These ten “CDx3 Selection Criteria” were first published in the first edition of Preferred Stock Investing in October 2006 and are now listed in chapter 7 of the current third edition, published in May 2009.

This table illustrates how the ten CDx3 Selection Criteria performed during the two-year long Global Credit Crisis. Notice that the preferred stocks from the banks that went bankrupt were unable to meet the ten CDx3 Selection Criteria (CDx3? = NO) to begin with.

And further notice that the preferred stocks that were able to meet the ten CDx3 Selection Criteria (CDx3? = YES) were the exact ones issued by the banks that were acquired and continue to pay dividends to this day.

Throughout the two-year long Global Credit Crisis, the ten CDx3 Selection Criteria, first identified in October 2006, successfully identified which preferred stocks to stay away from and those that would be safe, 100% of the time and in advance, protecting preferred stock investors. All dividends from the preferred stocks issued by these banks have been paid in full and on time. A 100% successful track record under the most extreme of conditions.

You can read about these ten specific criteria in chapter 7 of Preferred Stock Investing (see retailers).

Many Happy Returns.

When Does The Market For A Preferred Stock Become 'Illiquid?'

The financial press will occassionally caution investors about an 'illiquid market.'

But what constitutes an illiquid market for a preferred stock you may be considering and how does one tell before placing your order?

An illiquid market can occur when there are so few buyers and sellers that it becomes essentially impossible for any buy or sell order you may place to be filled. You'd hate to put together a plan to do a trade only to find out that, when you do so, your order just sits there day after day.

The degree to which the market for a particular preferred stock is 'illiquid' depends on the volume of shares that you are looking to buy or sell. What is illiquid to some investors will not be to others.

Look at it this way: Let’s say that you are looking to buy 100,000 shares. When you look up the daily volume of your preferred stock you see that it trades about 10,000 shares per day. You may still be able to buy 100,000 shares (10 times the daily volume), but it will take a very long time. Your buy order will sit there and get partially filled, a little here, a little there, day in and day out, probably for weeks. In the eyes of this buyer, the market for this preferred stock is extremely illiquid.

Now take a second case: Let’s say that you are looking to buy 10 shares of the same preferred stock. With a volume of about 10,000 shares per day, buying 10 shares is a snap; no problem. Your buy order will fill in seconds, if that. What illiquid market?

The degree to which the market for a stock is 'illiquid' depends on the percentage of the daily volume that you are trying to transact; in other words, the ratio of the number of shares that you are trying to buy or sell to the total daily volume of the preferred stock.

Here’s a rule of thumb that I use for CDx3 Preferred Stocks (nothing scientific here, just something I’ve noticed by watching every day): Your buy or sell order, placed in the morning at the 'Last' price, will generally fill the same day if you are buying/selling up to about 5%-7% of the daily volume. So if I were to place a morning buy order at the Last price for 700 shares, and the average daily volume was 10,000 shares, the order will almost certainly fill within the same day. If you try to buy/sell something closer to 10% of the average daily volume, your order may very well take more than a day to fill.

Online quoting services typically provide the day's share volume whenever you request a quote and most charting web sites will show the daily share volume along with the daily closing price history. If you are counting on your trade filling quickly (same day), it would be a good idea to understand what percentage of the daily volume you are transacting before you place your order. This can be especially true for older preferred stocks that either have a relatively low declared dividend rate or have already passed their call date.

Thanks to subscriber Alvaro P. for submitting this question.

Many Happy Returns.

Bargain Table Question

I'm curious as to why a stock trading over par would be on the bargain table. It won't have a capital gain if called ( in fact a loss) and it's capital appreciation is nothing to brag about.
Don

Trust Preferred Stocks - Why Not Just Issue A Bond?

There are three types of preferred stocks – traditional preferred stock, trust preferred stock and third-party trust preferred stock (see pages 31-35 of Preferred Stock Investing). From the investor’s perspective, there is very little difference. The difference exists to accommodate various reporting needs of the issuing company.

Enron made Trust Preferred Stock (TPS) famous by taking advantage of a loophole (closed in 2003). Now, for reasons that I will explain in a moment, only banks issue TPS’s.

When a company issues a Trust Preferred Stock (TPS), they first set up a new company (the trust). That trust sells the TPS shares to the investing public and loans the proceeds back to the issuing (parent) company. The issuing company, in exchange for this loan from the trust, issues a bond (usually a “junior subordinated debenture”) to the trust, which is a promise to pay back the loan plus interest.

Since the issuing company has to issue a bond to the trust, why bother issuing a TPS in the first place? Why not just issue the bond directly to the investing public and forget about the complications involved with setting up the trust and all of the recordkeeping that goes with it?

Here’s why: As the issuing company makes interest payments to the trust, the trust uses that cash to pay dividends to the investors who purchased the TPS shares from the trust. The trust is essentially a middleman, collecting cash interest payments from the issuing company and passing that cash on to investors in the form of dividend payments. The IRS collects taxes from the trust on the interest income that the trust received from the issuing company...unless the issuing company locates the trust offshore beyond the reach of the IRS in, say, the Turks & Caicos (think Enron here). Bingo, no taxes.

Also, reporting the TPS as “equity” on the company’s books, along with other common and preferred stocks, boosts the company’s all important “debt-to-equity” ratio, making the company’s SEC filings look more attractive to investors.

So TPS’s provided a double benefit – lower taxes plus stronger SEC filings.

New accounting rules in 2003 closed these loopholes. The issuing company is now required to pay taxes on the interest payments sent to the trust and the TPS shares issued by the trust are now required to be reported as a liability on the parent company’s books rather than as equity.

But a remaining disparity still benefits banks, specifically. Bank regulators watch a variety of metrics to assess bank health. “Tier 1 Capital” is a calculation that includes preferred stocks, including TPS’s. From this perspective, issuing a TPS allows a bank to raise capital plus boost their Tier 1 Capital metric, keeping regulators happy.

But regulators also keep an eye on another metric called “Tier 1 Common Equity” which includes common stock shares but, unlike Tier 1 Capital, does not include the value of preferred stocks that the bank has issued. When regulators changed their emphasis to Tier 1 Common Equity for TARP banks earlier this year, TARP banks began converting their outstanding preferred stocks (including trust preferred stock shares) to common stock shares, boosting Tier 1 Common Equity into the land of respectability in the eyes of bank regulators. Had banks issued bonds instead of TPS’s, they would not have had this option.

Trust preferred stocks provide banks (and, now, only banks) with a measure of flexibility that bonds do not when it comes to satisfying their regulators. For this reason, trust preferred stocks will continue to be issued by banks (and no one else). Thanks to subscriber Don L. for submitting this question.

Many Happy Returns.