11 September 2008 – The Aleph Blog

Too Bad for Preferred Stock

Posted on 11 September 2008 by David Merkel

From an old CC post:

		David Merkel
		Why I Don’t Like Preferred Stock
		6/9/2006 9:19 AM EDT

If I take risk, I want a decent probability of getting paid for taking the risk, and paid well. If I don’t want to take risk, I want a high degree of certainty that I’m not going to lose money, and if I do lose money, it won’t be much.

Having been a corporate bond manager in my last job (2001-03), I learned that I had all of the downside of stocks, with little of the upside of stocks. (One exception: buying MBNA floating-rate trust preferreds in late 2002 for $68 — they were at par ($100) in less than a year, matching the performance of MBNA stock, but that is rare, outside of distress situations. Another exception: fixed-income risk arbitrage was, in many cases, wider than that of equity arbitrage … examples from that era: Golden State, Household International and Allfirst, but I digress…

The situation is worse with preferred stocks. At least with corporate bonds you have a priority call on the assets of the firm in insolvency. Preferred stock typically gets 10 cents on the dollar in insolvency vs. 40 cents or so on senior unsecured corporates and 80 cents on bank debt.

Preferred stocks are called preferred because the dividend on the preferred must be paid for the common stock to receive a dividend. But with speculative ventures where the common doesn’t pay a dividend anyway, that is a small safeguard. Another small safeguard is the ability of the preferred holders to elect a few directors if the dividend is not paid. Nice, but it usually doesn’t tip the balance of corporate governance.

The recent troubles with Fannie and Freddie preferreds, where they lost 80%+ of their value, has hurt the preferred stock market.? Well, good.? Preferred stock is a vehicle that hates volatility.? The preferred holder just wants to clip his dividend payments and receive his principal back eventually.? He doesn’t benefit if the common rises (I leave aside convertible preferreds), and he is not protected during times of default.

This applies to all hybrid debt, trust preferreds, etc.? They may act like fixed income securities in good times, but in situations of economic stress, they behave more like equity than debt.

Be wary of those that promise high income relative to safer strategies.? It is rare that they succeed.

What’s Going Well, and What’s Not

Posted on 11 September 200822 June 2017 by David Merkel

The Wall Street Journal has an interesting article on the increase in exports from the US in today’s paper.? Also, they have this nifty interactive graphic that shows what areas of the US are benefiting most from exports.

Exports are a key to the new US economy.? Even though the dollar has rallied recently, it has become cheaper to manufacture many things in the US because the dollar is a lot cheaper than it was one to five years ago.? That makes US wages cheaper, and American workers are among the most productive in the world.

That’s the bright side of the US Economy, and it influences how I invest.? I pay more attention to global demand than to US consumer demand.

But now for the worries.

Money supply growth is anemic.? The Fed is not pushing on a string; the Fed is not pushing.? What strength they have is being directed toward solving financial market problems, not toward stimulating the US economy.? Banks are not expanding credit because they can’t afford to do it.
Residential real estate prices are likely (in my opinion) to fall another 10-20% across the US over the next two years.? That mortgage rates have fallen is a small help, but not enough to fundamentally change the situation.
The investment banks have cleared away some of their troubles, but they are still opaque, and their derivative books are possibly mispriced as a group.? Level 3 assets as a fraction of equity must come down.
Well, credit spreads have risen, but aside from financials, where are the junk bond defaults?? We had a ton of weak single-B and CCC issuance — where are the defaults?
There are a variety of weak finance companies that suffer in this environment, mostly due to their own foolishness: Chrysler, Ford, GM, AIG, mortgage insurers, and financial guarantors.

You’ll note that I have focused on financials.? That’s because in a credit-driven economy, if they are sick, then most of us are sick.

Regarding the fall in mortgage rates, that’s a good thing for financials, except that lending standards have tightened.? When we talk about the Fed “pushing on a string,” it means that when the banks are weak, lowering rates doesn’t do much; they can’t lend more because their balance sheets are weak.? With lower mortgage rates and tighter lending standards, the “pushing on a string” phenomenon reappears.? There aren’t that many people who can benefit from the lower rates, because many marginal buyers don’t have the wherewithal to meet the new lending standards.? That will change over time.? Indeed, when the Fed “pushes on a string” eventually their power is seen, delayed, but with a vengeance.? The same is true here, if mortgage rates stay low for long enough.

Things aren’t as bad as the bears put out, and are not as good as the bulls put out.? The economy is muddling with flattish growth as far as the average consumer sees, even if some export sectors are doing well.? That’s how I see it, and simplistic words like “recession” only cloud the picture.