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Old 04-24-08, 10:18 PM   #1
jschen
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question for the finance experts

Purely out of curiosity...

On CNBC, one person noted this morning that the major banks currently are issuing preferred stock with qualified dividends in the 8% range. And went on to point out that an all but guaranteed 8% return in a reasonably tax-efficient manner is a good deal. But in some cases, they're loaning out money at a lower interest rate. So... how exactly does this work out? I understand they're highly leveraged, but can someone enlighten me in detail how this is a winning proposition?

And hypothetically (since as a grad student, I'm not about to own a house, much less finish paying it off), why wouldn't someone with a house that's paid off take out a big mortgage and take that money to invest in preferred stock in the current situation? Borrowing at a lower interest rate that can be deducted against earned income and earning a higher dividend rate taxed at the qualified dividends rate sounds like a good deal to me, and spread out across multiple banks, there's probably not much risk that a significant number of them will go bankrupt.

So very confused...
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Old 04-24-08, 10:46 PM   #2
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The 8% dividend is not tied to a single portfolio of the bank's holdings, instead, its the bottom line that feeds the dividend. Banking business has become more fee based thus ALM management practices have changed a lot.
Regarding your house, would you consider it as another asset in your investment portfolio or the place where you give shelter to your family ???? It is for this reason that we are in this crisis, one must risk disposable income/assets, there are other assets you want to keep safe, as they are more than mere assets of your personal portfolio!!! Do not play with what you are not willing to let go!!! Conservative thinking??? you bet your ass!!! This is why I am now in the market purchasing property at great prices from people that did not think this way...
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Old 04-24-08, 11:07 PM   #3
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A few of the big banks (WaMu, Citigroup) that bet heavily on sub-prime mortgages now find themselves taking HUGE write-offs because those loans are going bad. Bank regulators require banks to have a certain amount of equity. Because of the huge write offs, the equity of these banks has shrunk to the point that they NEED to raise money. Sometimes the only way they can raise additional money is by issuing preferred stock - primarily to cash rich private equity funds (or oil rich investors). In the case of WaMu, the recent equity infusion may turn out to be a sweet deal - for the NEW investors. Current shareholders are taking it in the shorts because their investment interest has just been diluted and their dividend has been cut to .01$ per share.

In some (more likely most) of the recent cases, the sweet preferred stock deals were only available to a select few. The risk they take is that the funds raised for the bank aren't enough to bolster their thin equity position should additional write offs of sub-prime loans be necessary.

Right now, you're probably better off and safer owning senior secure debt of most banks, than by owning their preferred stock, much less the common. Also, dividends on preferred stock aren't necessarily guaranteed.

I certainly wouldn't be mortgaging my house to invest in preferred stock of a bank. Your house is a place to live, not an investment.
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Old 04-24-08, 11:56 PM   #4
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And hypothetically why wouldn't someone with a house that's paid off take out a big mortgage and take that money to invest in preferred stock in the current situation? Borrowing at a lower interest rate that can be deducted against earned income and earning a higher dividend rate taxed at the qualified dividends rate sounds like a good deal to me, and spread out across multiple banks, there's probably not much risk that a significant number of them will go bankrupt.

So very confused...
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Old 04-25-08, 09:09 AM   #5
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Purely out of curiosity...

And hypothetically (since as a grad student, I'm not about to own a house, much less finish paying it off), why wouldn't someone with a house that's paid off take out a big mortgage and take that money to invest in preferred stock in the current situation? Borrowing at a lower interest rate that can be deducted against earned income and earning a higher dividend rate taxed at the qualified dividends rate sounds like a good deal to me, and spread out across multiple banks, there's probably not much risk that a significant number of them will go bankrupt.

So very confused...
The problem you will likely encounter is with the fluctuation in the value of the individual preferred share.

Generally speaking, the amount of the dividend paid by a preferred share is fixed. The value of the share itself is not. The share will fluctuate in value with the fortunes of the company, that particular sector and interest rates. You will frequently see preferred shares selling at very attractive yields but you must carefully examine the underlying fundamentals of the company. You are getting that attractive yield because the market has decided that there is a higher level of risk involved with the investment.
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Old 04-25-08, 11:49 AM   #6
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The problem you will likely encounter is with the fluctuation in the value of the individual preferred share.

Generally speaking, the amount of the dividend paid by a preferred share is fixed. The value of the share itself is not. The share will fluctuate in value with the fortunes of the company, that particular sector and interest rates. You will frequently see preferred shares selling at very attractive yields but you must carefully examine the underlying fundamentals of the company. You are getting that attractive yield because the market has decided that there is a higher level of risk involved with the investment.
yeah, and the market also shows you what it thinks of preferred-shares. The people buying them are really after the dividends and the price of the preferred-shares themselves hardly ever appreciates.

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On CNBC, one person noted this morning that the major banks currently are issuing preferred stock with qualified dividends in the 8% range. And went on to point out that an all but guaranteed 8% return in a reasonably tax-efficient manner is a good deal. But in some cases, they're loaning out money at a lower interest rate. So... how exactly does this work out? I understand they're highly leveraged, but can someone enlighten me in detail how this is a winning proposition?
Also it's not a 1:1 ratio. They're not lending out exactly the same amount of money, like $100mil at 5% while at the same time, paying out 8% on that exact same $100mil.

It's very likely that the amount they are selling in that preferred-stock, say... $100mil, is more than offset by a much larger amount in lending at 5%. So if they're lending out $200mil at 5%, that would cover their 8% dividends with profit left over.

Also banks are much more diversified than that, and on average, a bank will actually be making 20% on your money (while paying you 2% for savings account). Same with insurance-companies, they make about 20% on your money too.
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Old 04-25-08, 11:59 AM   #7
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Preferred shares are often convertible too, into cash or common shares, so you're not guaranteed to be able to sit on that 8% dividend endlessly, they can yank the rug out from under you w/ early payment, or limited duration of the shares period (that's how they feel when you pay your mortgage off early).
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Old 04-25-08, 01:02 PM   #8
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Preferred shares are often convertible too, into cash or common shares, so you're not guaranteed to be able to sit on that 8% dividend endlessly, they can yank the rug out from under you w/ early payment, or limited duration of the shares period (that's how they feel when you pay your mortgage off early).
ding, ding, ding....we have a winner!

The banks are simply propping up there balance sheets at the moment so as not to be too low in equity/reserves, and since Preferred Shares actually get priority over regular stock, they are issuing this to entice quick sales/issuances. In a few years, after all the hoopla has settled down and the balance sheets are back to looking better, most of these preferred shares will be either converted to regular shares or redeemed. Its just a temporary influx the banks are looking for.
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