Combat Inflation with Floating Rate Securities (Forbes)

Fixed-Income Watch
Inflation Protection For Free
Richard Lehmann, 09.12.11, 6:00 PM ET

I have been pounding the table warning about rising interest rates for some time now. Well, it hasn't happened yet, and the latest Fed pronouncement makes it clear that short- and long-term rates will likely stay low for the next two years. My fear of rising rates caused me to recommend adjustable-rate securities. I was wrong on inflation, but my floating-rate picks have done quite well.

Since 2009 the adjustable-rate securities have enjoyed a spectacular resurgence, because most of them were issued by banks and other financial institutions that suffered huge declines during the financial crisis. These "too big to fail" institutions needed capital, and they issued all kinds of paper to bolster their books.

While fixed-rate issues experienced a similar rise, they are hurt by their call provisions. Specifically, most of the issues with a 5% or higher coupon rate are likely to be refinanced. This means they're trading on a yield-to-call basis with measly returns measured in basis points rather than percentages (100 basis points equals one percentage point). Most are trading above the par value at which they will be redeemed. Those who bought fixed-rate capital note preferreds with high coupons, issued by the troubled banks in 2008, thought they would be safe from call until 2013. Not so.

Congress and the Dodd-Frank Act foiled this seemingly smart strategy. That act says these preferreds can no longer be considered part of a bank's tier-one capital. This triggers a "statutory change" loophole that now allows banks to call these fixed-rate preferreds early. Think of it as Chris Dodd's going away present to his banker buddies.

Adjustable-rate securities normally trade at lower yields than comparable fixed-rate securities. They pay interest monthly or quarterly based on a Treasury bond index, LIBOR or changes in the CPI. The floating rate means these notes are designed to trade at par. But this hasn't been happening. That is because these securities come with an interest rate floor, typically at about 4%. When these bonds were issued that was considered meager. Today a 4% yield is a king's ransom.

Despite the healthy yield floor, most of these adjustables are selling below par today because they are viewed as inflation hedges in a period when inflation fears are absent. Thus you can still buy these adjustable-rate securities below par value. That is like getting a dollar for 90 cents. Hence, inflation protection is free, and the call risk is a positive. Once inflation fears are rekindled and rates spike, you'll be all set with these floating-rate securities.

Here are some adjustables you should consider buying:

AEGON NV SERIES 1 (AEB, 17) PERPETUAL PREFERRED RATED BAA2/BBB/BBB. This Dutch multi-line insurance giant was hard-hit during the financial crisis and still suffers under the weight of European banking concerns. This preferred is adjustable quarterly based on three-month LIBOR plus 87.5 basis points. It has a 4% floor and no ceiling, so at its current price it yields 5.71%. Even better, it's eligible for the 15% qualified dividend income tax rate for those in the highest tax bracket.

Closer to home I like GOLDMAN SACHS SERIES A PERPETUAL PREFERRED (GS A, 19) RATED BAA2/BBB–/A–. It has a floor rate of 3.75% and no ceiling and is tied to three-month LIBOR plus 75 basis points. It yields 4.93%, and it also benefits from the preferable tax rate on dividend income.


If you are willing to accept more risk buy the SLM CORP. 0% OF 3/15/17 (OSM, 21) RATED BA1/BBB–, yielding 6.15%. SLM is better known as Sallie Mae, the student loan organization, which went private in 2004. This adjustable is different in that it pays monthly, based on the percentage change in the year-over-year Consumer Price Index, plus 200 basis points. It has no floor or ceiling rate and currently pays 5.164%. I like it because there is no delay in recognizing an uptick in inflation, but unfortunately it isn't eligible for lower tax treatment.

I thought rates would climb because the Fed would use inflation as its primary tool in curing our economic woes. Bernanke flooded our economy with dollars, but inflation failed to materialize. Our economy was much weaker than I thought. Dark clouds still hang over global markets. While inflation is not an immediate concern, it can and does crop up when it's least expected. Given the current international turmoil and clearly nervous markets, investments offering inflation protection at no cost are a gift I find hard to resist.

Potential for Countrywide Default (Bloomberg)

BofA Keeps Countrywide Bankruptcy as Option

By Hugh Son and Dawn Kopecki - Sep 16, 2011

Bank of America Corp. (BAC), the lender burdened by its Countrywide Financial Corp. takeover, would consider putting the unit into bankruptcy if litigation losses threaten to cripple the parent, said four people with knowledge of the firm’s strategy.

The option of seeking court protection exists because the Charlotte, North Carolina-based bank maintained a separate legal identity for the subprime lender after the 2008 acquisition, said the people, who declined to be identified because the plans are private. A filing isn’t imminent and executives recognize the danger that it could backfire by casting doubt on the financial strength of the largest U.S. bank, the people said.

The threat of a Countrywide bankruptcy is a “nuclear” option that Chief Executive Officer Brian T. Moynihan could use as leverage against plaintiffs seeking refunds on bad mortgages, said analyst Mike Mayo of Credit Agricole Securities USA. Moynihan has booked at least $30 billion of costs for faulty home loans, most sold by Countrywide during the housing boom, and analysts estimate the total could double in coming years.

“If the losses become so great, how can Bank of America at least not discuss internally the relative tradeoff of a Countrywide bankruptcy?” Mayo, who has an “underperform” rating on the bank, said in an interview. “And if you pull out the bazooka, you’d better be prepared to use it.”

Countrywide Practices
Just before former CEO Kenneth D. Lewis bought Calabasas, California-based Countrywide, the firm was the biggest mortgage lender in the U.S. with 17 percent of the market and $408 billion of loans originated in 2007, according to industry newsletter Inside Mortgage Finance. Regulators later found its growth was fueled by lax lending standards, with loans marred by false or missing data about borrowers and properties.

Bankruptcy for Countrywide has gained credence with some investors and analysts after Bank of America lost almost half its market value this year. The shares have been whipsawed as the caseload of lawsuits by mortgage bond investors expanded, along with doubts about whether the bank has enough reserves to handle claims.

A Countrywide bankruptcy could halt legal proceedings and consolidate litigation into one court that would split up the subsidiary’s remaining assets for creditors, said Jay Westbrook, a law professor at the University of Texas at Austin. In effect, this would trade one type of litigation for another, one of the people said. The decision would turn on whether the potential savings of a filing outweigh the risks involved in disavowing some of the firm’s obligations, the person said.

What Could Go Wrong
Pitfalls include the possibility that a bankruptcy filing would cast doubt on the entire company’s willingness to support its other subsidiaries and damage Bank of America’s standing in the credit markets or with rating firms, hurting its ability to borrow, according to analysts.

“It’s not some sort of magic elixir that makes it all just go away,” Westbrook said. “I suspect that’s one reason they haven’t done it yet.”

Moynihan, 51, has been asked publicly about a potential Countrywide bankruptcy at least three times in the past year, most recently this week at a conference in New York. The bank’s mortgage division is his only unprofitable business, reporting a $25.3 billion pretax loss in the first half of this year.

Larry DiRita, a Bank of America spokesman, said he couldn’t comment on whether the company planned to file a Countrywide bankruptcy. The bank “took great pains to preserve the separate identity of Countrywide,” DiRita said.

Separate Accounting
Those steps include using separate accounting systems and profit-and-loss statements for Countrywide units, according to a report prepared for Bank of New York Mellon Corp. (BK), the trustee for a group of investors who agreed to an $8.5 billion settlement in June with Bank of America over faulty loans.

Bankruptcy “makes absolute good sense if they can do that,” said David Felt, a Washington-based consultant and former deputy general counsel at the Federal Housing Finance Agency. The FHFA sued Bank of America and 16 other banks this month to recover losses on about $200 billion in mortgage-backed securities sold to Fannie Mae and Freddie Mae, the government- backed mortgage firms. Bank of America and its subsidiaries created more than a quarter of those bonds.

“Given the size of these lawsuits, the potential liability could exceed the net worth of the subsidiary,” Felt said. “They could say the claims far exceed the amount that we have and therefore we need a bankruptcy court to pick and choose between those creditors.”

Assets Available
Countrywide has $11 billion in assets that could be depleted through demands to repurchase defective mortgages, Jonathan Glionna of Barclays Plc said in an Aug. 31 note. After that, Bank of America may not have any obligation to pay claims from Countrywide’s creditors, he said.

Typically, a corporation that acquires another firm’s assets isn’t liable for the seller’s debts, unless the transaction is considered a de facto merger or there was fraud in the takeover, Robert M. Daines, a Stanford Law School professor, wrote in a legal opinion prepared for BNY Mellon, trustee for the Countrywide mortgage bonds. Daines analyzed whether Bank of America would have to pay bond investors if Countrywide couldn’t.

American International Group Inc. (AIG), the insurer that sued Bank of America last month to recoup more than $10 billion in losses on Countrywide mortgage bonds, argued that the bank is a legal successor to the unit. New York-based AIG cited a series of transactions by Bank of America in 2008 that “were structured in such a way as to leave Countrywide unable to satisfy its massive contingent liabilities.”

Just in Case
Plaintiffs in the $8.5 billion settlement handled by BNY Mellon didn’t take any chances. Their agreement specified that Bank of America was responsible for making good on the payment because they were concerned that Countrywide might be thrown into bankruptcy, said Bob Madden, a Gibbs & Bruns LLP partner representing institutional investors that sued the bank.

“Bank of America didn’t do this stuff, it was Countrywide, which they had the misfortune of acquiring,” Madden said in an interview. “Anybody who tells you they have a solid handle on whether Bank of America can be forced to pay Countrywide liabilities hasn’t looked very closely at the issue.”

The chances of a bankruptcy filing rise “every time another suit gets put on the pile,” Madden said. Mark Herr, a spokesman for New York-based AIG and Stefanie Johnson of the FHFA declined to comment.

Bankruptcy’s Backlash
Bankruptcy would be a “last-ditch option,” and possibly a costly one, because counterparties might become hesitant to buy the parent company’s debt or open trading lines with its Merrill Lynch unit, David Hendler, a CreditSights Inc. analyst, said in a Sept. 8 note. Credit-rating firms could downgrade Bank of America subsidiaries, which benefit from the implicit support of their corporate parent, he said. That would drive up the bank’s cost of borrowing.

“Most counterparties I speak to think this would be a very difficult option for Bank of America and unlikely to be sanctioned by regulators,” said Manal Mehta, a partner at Branch Hill Capital, a San Francisco-based hedge fund that has bet against the lender’s stock in the past. “The whole reason they would pursue the nuclear option of a Countrywide bankruptcy would be to put this behind them, but all you would be doing is opening up a Pandora’s box.”

Outstanding Debt
Countrywide has $6.53 billion of debt outstanding, including $2.81 billion of senior unsecured notes, $2.2 billion of preferred securities and $529 million of mortgage-backed bonds, Bloomberg data and Bank of America figures show. The unit’s $1 billion in 6.25 percent notes have plunged 9.2 cents since Aug. 1 to 97.1 cents on the dollar as of Sept. 13, according to Trace, the bond price reporting system of the Financial Industry Regulatory Authority.

Management’s public stance on a potential Countrywide bankruptcy has evolved. In November, responding to a question from Mayo -- who had written a report that month entitled “Is a Countrywide Bankruptcy Possible?” -- Moynihan said he didn’t “see any liability that would make us think differently about working through it in the way we’re working.”

Since then, damage from Countrywide has steadily mounted as U.S.-owned Fannie Mae and Freddie Mac step up demands that the bank repurchase soured loans and new suits emerge, including from AIG and the FHFA. Further, New York Attorney General Eric Schneiderman is seeking to scuttle the $8.5 billion deal, which may result in greater mortgage costs, Bank of America has said.

Last month, when Moynihan was asked during a conference call held by fund manager and bank shareholder Bruce Berkowitz if a Chapter 11 restructuring would be a “viable solution” for Countrywide, the CEO declined to say what he’d do.

“When you face liabilities like this, we thought of every possible thing we could,” Moynihan said, “but I don’t think I’d comment on any outcome.”

To contact the reporters on this story: Hugh Son in New York at hson1@bloomberg.net

To contact the editor responsible for this story: Rick Green in New York at rgreen18@bloomberg.net.
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