The Great Financial Crisis happened 10 years ago. The joke that was going around the bank I worked for at the time started with the question “What’s the difference between now and the Great Depression?”
The punchline: “This bank survived the Great Depression.”
Watching the financial world unravel from inside a bank was unreal. There was a constant stream of people sneaking in and out of the bank as they combed over our books to see if we were worth saving. Deposits were being pulled left and right and clients were asking us whether they should move their money elsewhere or if they should stick it out with us. Our cost of funds went through the roof even and our risk culture flipped on its head to the point where a Deputy Chief Credit Officer in our C&I book wouldn’t even approve a cash-secured letter of credit for a client.
Among all the noise and knee-jerk reactions our core book of business actually held up pretty well. We had appropriately managed the risk inherent in our portfolio but we were being punished by the bloodbath in real estate and the spillover effects of too much leverage in the financial system.
Sharks in the water
The drama at the bank I worked at was my first introduction to watching professionals play in the parts of the capital structure that didn’t involve equity or senior debt. In an effort to save the bank Management created a new class of preferred shares to sell to a group of private investors. Those preferred shares had some snazzy features. During the darkest hour of the bank, with common equity shares trading in the low single digits and these new preferred shares trading around $7 when par was $25, word finally came out that the Treasury Department voluntold another bank to buy us and the Treasury Department was providing the liquidity to make it happen.
The other bank bought our common equity at slightly below market for what is known as a take-under, which is something else that isn’t supposed to happen in finance. A huge number of employees saw their retirement accounts and option awards become worthless because of the culture of encouraging employees to invest in the bank. The preferred shares held primarily by the private equity group? They jumped up to par.
Who had bought those preferred shares when they traded down to $7? This guy.
Who was an almost broke grad student who only had a couple bucks to put into that trade? This guy.
It was a good bet but not one I could retire on.
Great Financial Crisis Tier 1 Capital Engineering
One of the results of the GFC was that regulators wanted banks to shore up their Tier 1 capital ratios and decrease the amount of balance sheet leverage they used to run their business. As you can imagine, Management and shareholders weren’t interested in getting diluted at the bottom of the cycle. Instead of forcing banks to issue more common equity the regulators wrote the rules so that banks could issue preferred shares. Preferred shares don’t dilute common equity holders and they don’t count towards the bank’s leverage profile.
However, banks weren’t considered attractive investments at this time so the investment bankers had to put some unique features in the preferred share offering to entice investors to buy them.
Typically this is where you would cite the sweetheart deal Warren Buffet got with his preferred shares and warrant kicker, but I’m not going to do that.
Instead I’m going to focus on the L-Series preferred shares offered by Wells Fargo and Bank of America
$WFC-L and $BAC-L Preferred Shares
The L-Series of preferred shares for Wells Fargo were originally issued as Wachovia shares in the early months of 2008. They turned into Wells Fargo shares when Wells Fargo purchased Wachovia in December. The par value of the WFC-L shares is $1,000 with each share paying out $18.75 per quarter, or $75 per year. Unlike almost all other preferred shares, these are not callable by the company. Instead they are convertible. What’s truly unique these preferred shares issued during the GFC is that the shareholder can convert each share into 6.38 shares of Wells Fargo common stock at any time and for any reason while Wells Fargo can force a conversion only if Wells Fargo’s common stock exceeds a market price of ~$204. If this happens, then each preferred share would be converted at $1,300 or 130 percent of par. Given where WFC is currently trading, this isn’t likely to happen any time soon.
These conversion details are extremely important when buying something above par. If you don’t read the fine print and buy a preferred share at $1,200 and it gets called the very next day at par then you’re sitting on a 20 percent loss and there’s nothing you can do about it.
The preferred shares for Bank of America are similar. They were issued in the early months of 2008 and their structure is effectively the same except they can experience a forced conversion when the common equity of Bank of America is above $65 per share.
L-Series Preferred Yield
These days the L-Series of WFC and BAC yields around 5.7 percent as they both trade just shy of the $1,300 conversion price. I would argue that the 5.7 percent yield is mispriced since both Wells Fargo and Bank of America are considered too big to fail. It’s not as risk-free as a US Treasury bond, but at almost twice the yield there’s enough of a difference to make it worth it. These should be trading higher than what they are but my assumption is that investors haven’t taken the time to understand the conversion mechanism and are just assuming that they work like all the other preferred shares out there.
A 5.7 percent preferred with the unique features of the L-Series from a business like WFC and BAC is significantly more attractive than the average junk bond in today’s yield environment. If nothing else, these two preferred shares should at least go on an investor’s watch list for the next time they sell off.