Description

I realize there have been numerous ideas posted about buying financial preferreds.  I believe this idea is somewhat different and timely.   I apologize in advance for spelling/grammar errors. 

I propose buying Merrill Lynch Trust Preferreds securities currently yielding 16.4% (they range from 15.5 to 16.4) and shorting Bank of America Preferred Trust’s yielding 11.5% to 12.5%. 

The actual trade I put on today is buying MER E ($11.07) and shorting BAC B ($13.75) which are yielding 16.4% and 11.6%, at closing prices.  I am net long MER E but for the balance of this write-up I am going to mostly focus on the pair trade. 

I am not going to go into too much detail about the Trust Preferreds.  They are cumulative and senior to the government preferred.  You can look at previous write-ups on Wachovia/Wells Fargo to see that the Merrill and Bank of America preferreds are IDENTICAL in the capital structure and there is no reason for this spread to exist.  I believe that the spread will dramatically narrow over the next few weeks as investors get comfortable that BAC is not nationalized and continue to narrow over the next year.  I see three outcomes:

1)      Preferred dividends are eliminated.  Both Merrill and Bank of America’s preferred plummet and most like go to near 0.  The spread will almost certainly be 0 or close to 0 at that point.

2)      Investors get comfortable in the short term that the dividends are safe and that the government will not nationalize BAC.  BAC’s Preferred yields return to 8-10%, where they were in December and January.   Note:  These are still very high yields, especially in a 3% long bond environment.

3)      Status quo.  BAC Preferreds remain in the 11.5 to 12.5% range. 

If events #1 or #2 were to happen, I believe with almost certainty the spread narrows and I detail it below.  If event #3 happens, over time, I believe the spread narrows.  Note:  I highly doubt these high yields will exist a year from now.  It is vastly more likely that events #1 or #2 happen.

There are a few ways to look at the opportunity here:

1)      Some history:  When BSC merged with JPM, there was a big spread that narrowed.  WB and WFC, also the same thing.  Currently, BSC and WB Preferreds yield about 100bp more than JPM and WFC.   So, if situation #2 where to occur, we could assume with reasonable confidence that the Merrill spread would not remain at near 500bp.

2)   For the record, the current yield on BSC, JPM, WB, and WFC are 9%, 8.3%, 9.6%, 8.7%.

3)      Bank of America has outstanding preferred debt on Countrywide.  CFC A is the ticker.  The current yield is 14.5%, 200bp lower  than Merrill and 300bp higher than BAC.  There is no basis for the gap.  The fact that the Countrywide deal has been closed for a longer time than Merrill is the main reason it trades at a premium to Merrill.  If you go back many months you will see Countrywide used to have a similar spread as Merrill now has.   This to me shows that over time, even if the yields stay the same as they are today, the spread will narrow.   Also, Fleet has outstanding preferreds yielding 13.7% that are also part of BAC.  Ticker FBF N. 

Note:  The best way to put the trade on is not dollar neutral.  The BAC B’s have a 6.25% coupon and the MER E’s have a 7.12% coupon.  I believe you should short 1.14 shares of BAC C for every 1 MER E you purchase to “normalize” the coupon.  Your net dividend will be 0.  To use a few examples,  If BAC preferreds went to 10% and MER went to 12% you would make $3.98 on the MER and lose $2.36 on the BAC for a net gain of $1.62 or 14.6%.  If they both went to 0 you would lose $11.07 on MER and make $15.765 on BAC for a net gain of $4.60, or 41% return.  This $4.60 represents the maximum gain if the spread were to collapse to 0, either on the upside or downside.

There are many different Trust Preferreds and amazingly the spreads can vary 75bp on any individual name even though they are all identical.  The MER tickers are K, M, D, E, F, and P.  The BAC tickers are U, Y, Z, B, C, V, W.  I had trouble getting a borrow on the C’s.  You should compare all of them to make sure you are putting on the largest spread as it changes daily. 

I am net long the Merrill Preferreds as I believe they make an excellent standalone investment.  I do not believe the dividends are eliminated or suspended.  Note, these are cumulative preferreds so if it is suspended we would get paid before common ever did in the future.  Also, they are trust preferreds senior to the government's investment which I realize means little in todays environment.  Obviously, this is a much riskier investment and we can each come to our own conclusions on what the outcome will be. 

Catalyst

Government either does or does not nationalize Bank of America. 

Time. 

RISKS:  Spread widens, you get bought in on the short.