Saturday, May 26, 2012

Santander Preferreds: Are North American Grandmothers brave, ignorant or insane?

There is - at least amongst North American grandmothers who are the natural buyers of American listed bank preferred securities - a love of yield.

Santander (the Spanish mega-bank) has preferred securities issued in America - they mostly replaced the preferred securities of Sovereign Bank - a Santander-owned US regional bank. 

But they are equity securities of Santander - taking full equity risk for a high (but limited) yield. 

Linked (here) is the Google Finance page for one such security. Par value is $25 and the last trade is $25.65 - a small premium to par.

What could possibly go wrong?

OK: plenty could go wrong - but we don't need to analyse whether the Spanish mega-banks will succeed or fail - all we need to do is observe how bizarre the pricing is. Why would you own this preferred when you could own the common? The ADR is trading at $5.66 - and good earnings (2009 would you believe) were $2.24 per ADR. The common is two and a bit times normalized earnings. The no-failure earnings yield on the common is 40 percent (and if it does not blow up you will get capital appreciation). The prefs are at 10 percent yield.

There is a good chance that Santander never again earns "normalized earnings". There is a crisis going on... 

But go tell that to the preferred holders who are happy to take a very similar risk to the common for a 10 percent yield and no chance of capital appreciation. They must envisage a world where Santander is saved by equity dilution that somehow leaves them intact. After all they are presuming (through their holdings) that the preferred is more attractive than the common.

And they believe that just as the Spanish Government injects 24 billion euro into Bankia.

Brave. Or is it ignorant? 

Or do the holders expect the Spanish government to bail out banks at no cost to the preferred holders as per much of North America? That does not seem likely to me. Or even possible.


PS. I lost good money on Washington Mutual preferred stock. But I purchased them at 25 cents in the dollar. This one is going to trade there very soon in my estimation. 

Disclosure: trading short on the preferred. Covered the common a few dollars up from here. But you guessed that.

PPS. In the interests of disclosure I should note that the borrow has become tight on this security (which  from my perspective is a pity).


john b said...

Possibly this view reflects the fact that my training's accountancy (where they unequivocally are debt) rather than law, but surely preferred shares are treated as debt rather than equity?

Agreed, I certainly wouldn't hold them.

John Hempton said...

For regulatory purposes they are equity... they will fail with the equity.


Nemo Incognito said...

Prefs in banks are loss given default = 100% territory. So, take the default probability curve using an assumed senior recovery for Santander and the price is so wrong its not funny.

This isn't all that unusual though.

Rich said...

I don't understand STD vs. Citigroup.
Why on earth would people buy a world-girdling Spanish bank vs. a US bank at a higher PE and higher price to book?

My surmise is that there are yield hogs who look at the high dividend that STD pays. Buy, and hope.

Since a large part of the STD common dividend is paid in stock, I guess it's sustainable, if you like getting taxed on your own dilution.

Just another example of the efficient market theory in action!

ptuomov said...

How about pairing that preferred stock short with long 2014 calls on the common? Might end up being a really cheap straddle relative to the binary distribution of outcomes by 2014.

bryan willman said...

hunger and need. grandmothers and other retirees often do not need or want future capital gains, they want regular cash flow. it seems a lot of people are chasing cash flow, and taking ever greater risks to get it.

Anonymous said...

I love this idea John. However - taking STD PRE - as the test case, the costs on this short investment look huge. You have a loan fee of between 7.5% and 8.5%, and in addition to that you are on the hook for a 10.5% dividend? So we are swinging for a major liquidity event in the next 12 months, and we are out near 20% of the investment if it stands still?

John Hempton said...

Mr Persistentone...

I only blogged this one after the borrow became tight.

I suspect that it is a very cheap loan for four weeks - and at the moment we will have some clarity in four weeks.

But if the borrow had remained freely available I would not have blogged it. I would have just got shorter and shorter.

Anonymous said...

So you are treating this as a binary event based on the June Greek elections? Like everything in this drama, I'm not so sure it unfolds cleanly. They may not fix problems, but the Europeans are masters at deferring them. In any case I see the case for the bank run in Spain pretty clearly, and you are absolutely right this is not priced in.

Looking out 12 months, it would be good to see you post long candidates in Southern Periphery who are primarily exporters. At some point if Southern Europe has a bank run, leaves the Euro, and devalues, their corporate entities will be smashed due to devaluation of their earnings. But those who are primarily exporters will have a strong component of untarnished earnings and may end up being buys of a lifetime. Too early to get in today, but time to start studying and watching them.

Aharon L said...

Addressing your headline directly--and speaking as someone with two North American grandmothers, now sadly both deceased--I can assure you that they are all three.

Anonymous said...

As a fixed income analyst in a private wealth shop, I can almost guarnatee you that the grandmothers have no idea what a preferred stock really is. They are at the mercy of the knowledge of their financial advisor... who certainly does not know credit and almost certianly knows only slightly more than grandma. It is a sad state of the industry. I would point out that when RBS was nationalized, preferreds did not go to $0 (but very low) as the dividend was deferred for two years. It becasme a non-income instrumkent and rather a capital appreciation hoping instrument.

Miles Willcod said...

Great post and blof as always John.

One part that may be important to your thought process:

"Why would you own this preferred when you could own the common?"

The pricing delta can be explained in part by a rights issue, which would leave the preferred whole (albeit dividendless for a while).

John Hempton said...

Santander is past the "simple rights issue" stage. If this company needs a rights issue the rights issue will fail.

This is the point where if they required capital nobody would believe them.


Anonymous said...

Of all the spanish banks this is the one I would not be sure about. The brazilian arm seems quite strong and it could sell further shares in its Mexican subsidiary. It also has Kredyt bank in Poland, SEB in Germany and abbey in the UK. Still I take your point about the pricing.

Anonymous said...

This is a national champion, pure and simple. On that basis I like long the senior, short Spanish sovereign CDS against it. The sub is difficult though, given the borrow costs as you say. Does much of that stuff live in TRuPS CDOs? That might explain some price dislocation too.

patrick said...

John, great post as always, but reading the prospectus it says that these prefs are , in the event of bankruptcy, entitled to recieve, before any asssts are distributed to holders of ords.....face and any accrued and unpaid divis (page 50) as far as I can see if the manure hits the ventilator you could have a situation that the prefs do get something and you get a goose egg on the ords...or am I missing something

patrick said...

John, if this is a repeat please ignore, my browser crashed when i pushed "publish" but as far as i can see on page 50 , in the event of liquidation, the pref holders will get paid par plus any accrued divis before the ord holders get a cent. should that not imply that they are ahead (maybe just slightly) in the cap structure of the bank and as such have a different risk profile on the downside vs the ords. It seems to me the basis of your trade is that they have the same risk profile..what am i missing?

Miles Willcod said...

Tell that to Banco Espirito Santo....

I don't violently disagree - but bank shareholders aren't the most rational bunch

As I said, I love the blog and thank you for sharing

John Bird said...

Thank you for what may be the perfect short. The price is effectively capped and the downside is obvious. The borrow costs even inclusive of the dividend reimbursement are quite low compared to equally attractive shorts.

The virtual certainty (IMHO) will be a 2 or 3 year dividend holiday forced on STD by the government. Price should fall to ~12. This exact scenario played out with Royal Bank of Scotland and Citi had a similar suspension. There is also the virtual certainty of a major downgrade on all the STD prf's within weeks.

What is so fascinating to me is that the prf's have remianed untouched by the debacle that has driven the common down 60%. I can only presume that since the prf's are exclusively a US instrument the blood in the water haas been missed here.

I personally took down a chunk today and will do more shortly....pun intended.

FD said...

Downside probably limited, in fact.

Mr. Hempton, you're quite right when you say that the prefs are over priced and if one's to take a flyer, then the common is the way to go. And yes, the asymmetry is positively tilted on the common and negatively tilted on the prefs.

BUT, if the recapitalization is anything like the way these things are typically done, then the existing preferreds should not only stick around, but perform as well.

Historically, recapitalizations constitute injecting new preferred equity with warrants alongside existing preferreds. The recent recaps of Citi, BoA et al were no exception.

To toot my own horn here, I bought, in 2008, closed end preferred stock funds trading at 25% current yields and 25% discounts to NAV. As you know, preferred stocks are typically issued by utilities and... BANKS. I understood the recap structure and selected the funds that were heaviest in bank preferreds. 12-18 months later, I more than doubled my money on a total return basis.

Anyway, good observation and good post: Yeah, the prefs have no upside. But in all likelihood they'll stick around and perform.

Anonymous said...

Why the preferreds instead of the common? The preferred dividend can't be cut, the common's dividend surely can, and with ease. Instead of buying into an unknown rate and increasing the risk with Fx risk, which the US listed ADRs have, an investor gets a known rate.

Many references to RBS are completely in error and obviously misunderstood. Certain RBS preferreds continued to pay, some were deferred. The ones that paid had "distributable profits" language in them that required them to pay. The STD prefs have the same language. Please check facts before comparing. Oh, and RBS was never nationalized. Analysis is the key here.

As well, preferred stock is not equity. Yes, it falls under shareholders equity, that much is true. It is senior to common equity in the right of payment - prefs don't get paid, common doesn't get paid. Look at historical precedents - government funds came in parri passu with the preferreds and then diluted the heck out of the common.

As well, please realize that STD is a global bank located in Spain. Their Spanish and Portugese exposure is under 20% of their earnings. Also realize the capitalization levels of the bank - comparison to Citi is humorous at best. Troubled loans? Look at the provisions - post new govt increased amounts.

Just a couple thoughts on some glaring inaccuracies and misguided comments.

preferred stock said...

Nice blog. Please do share types, payment schedules & their rating criteria.

preferred stocks

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