Description

Popular Capital Trust II (BPOPM)

We believe the market is confused about Puerto Rico and has sold off BPOP debt together with Puerto Rico’s municipal bonds. While much of the municipal debt will almost certainly receive a large haircut post-restructuring, BPOP is a well-capitalized Puerto Rican bank that will weather the storm. The TruPS offer compelling value here. In particular, we like the BPOP 6 â…› 12/01/34 (POPULAR CAPITAL TRUST II, hereafter referred to as BPOPM).

TruPs Structure

BPOPM are legacy Trust Preferred Securities (TruPS) that have been phased-out from Tier 1 Capital and only qualify for Tier 2 Treatment under Basel III. While they are immediately callable, we believe the bank will call and replace them together with the Senior Unsecured which matures in 2019. We believe these securities have a tremendous equity cushion beneath them and investors are getting well-compensated for taking on this risk. At today’s prices of 21.15, the yield to a December 2019 call is 14.5%, while the yield to maturity in 2034 would be 7.7%.

Fortress Balance Sheet, Plenty of Capital

BPOP is an extremely well-capitalized bank. With $4.5bn of equity and $540m in reserves versus $17bn of Puerto Rican loans, a lot has to go wrong before the TruPS would become impaired. Markets are ignoring the difference between an earnings and a credit event, as the TruPS have traded down in-line with the equity since the landfall of Hurricane Maria on September 20th, without taking into account the deep structural subordination of the TruPS.

The Balance Sheet

Severe Credit Stress Test Results

Out of $22.6bn in loans, $17.3bn are in PR and another $5.3bn outside of Puerto Rico, where it acts mainly as a bank for the Puerto Rican Diaspora. The loans outside of Puerto Rico are unlikely to be materially affected by the disaster. Nevertheless we model a sharp recession scenario for the mainland US loan book.

Even subjecting both the US and Puerto Rican loan book to a stress test in which BPOP instantaneously realizes losses of $2.7bn, the bank would surface with a 9.4% CET1 and 6.2% leverage ratio, slightly below the US average of 11.3% but still not undercapitalized. Note that we are not certainly not expecting losses anywhere near these levels as a base case, but rather, want to show that BPOP debt comfortably survives even a draconian credit stress test with plenty of headroom.

In contrast to this number, the Morgan Stanley analyst covering BPOP, is only expecting “provision expense of $245MM in 2017 and $205MM in 2018”. This would still leave the bank with a net profit of $350MM in 2017 and $407MM in 2018. Moody’s also affirmed BPOP’s deposit rating at Ba2 on the 10th of September, citing that “banks could increase their provisions by almost tenfold over the latest quarter's provisions”, but even if “such heightened provisions were taken, their capital ratios would still meet the regulatory well-capitalized minimum for total risk-based capital of 10%.”. In the case of BPOP a tenfold increase in provisions would still only equal $520MM.

In reality, even in our severe stress shock case, BPOP would only realize losses over several years, while continuing to earn back its losses. Even if we assume $1.5bn in stressed losses, or about 3.0x the Moody’s case, BPOP is making about $690MM in run-rate annual pre-provision net revenue, enough for BPOP to earn back its losses in a little over two years.

In addition, BPOP has only very limited Puerto Rican government exposure with only $451MM in outstanding loans to municipalities, which are backed by real and personal property taxes, municipal excise taxes, and a percentage of the sales and use tax. Finally, about $560MM of BPOP’s loans are covered under an FDIC loss-sharing agreement which BPOP entered into after DoralBank went into receivership in 2015. The majority of losses on these loans would fall onto the FDIC.

Summary

While we don’t find BPOP equity compelling given its valuation and the substantial problems Puerto Rico faces, we believe the protection afforded to a TruPS holder from the massive tangible equity and reserve cushion render them a safe investment. As we expect these securities to be called in 2019, the BPOPM’s should be viewed on a Yield to Call basis. In a market where it is difficult to find a safe yield of 6% (see north481’s post on SCHW 6 PERP Pfd for detail), we view the 14.5% YTC as an attractive risk-reward.  We find this yield particularly attractive as an expected call in three years limits interest rate duration risk while achieving a double digit yield.

Catalyst

Short time to Call; Earnings and provisioning