Distressed Bank Investors Are Aiming for Preferred Treatment

By PETER EAVIS No investor has nine lives. But those who think the recent bank-stock recovery is more than a dead-cat bounce are making some interesting bets. As well as buying banks' common shares and certain types of bank debt, they are dabbling in banks' preferred stock. These preferreds have been mauled as the financial system has come under stress -- and tend to move with whiplash volatility. Certain institutions have seen their preferreds wiped out completely, or their dividends rescinded, which destroys their value. And if the government's bank rescue shows signs of failing, preferreds could tank again, even at the stronger banks. But to some, the preferreds look enticing. They have recently rallied after the government detailed plans to bolster bank capital and after Citigroup announced plans to convert a large amount of its preferreds into common shares at reasonable terms. The PowerShares Financial Preferred ETF is down 59% over the past 12 months. But it is up more than 66% since its low on March 9, compared with a 44% increase since then for the BKX Bank Index, a common-stock index. The case for the preferreds can be seen in Bank of America's noncumulative, Series L preferreds, which trade around 38% of par value. These could do well in two possible scenarios. First, what happens if the government stress tests prompt Bank of America to convert these into common shares to boost its tangible common equity ratio, as happened at Citi? The Citi example suggests that a bank preferred holder could convert at 85% of par. That would mean each Series L preferred collecting $850 in common shares. The government bank plan already has set a formula for converting preferreds into common, and at Bank of America that prices the latter at around $6.20. Dividing $850 by $6.20 would give the preferred holder 137 common shares. At Monday's stock price of $6.03, those would theoretically have a combined value of about $826 -- well above the $380 the Series L costs. There are risks. To lock in such a gain may mean shorting the common, which could be seriously expensive, as proved by the Citi deal. Unhedged investors, meanwhile, would need to worry about the common-stock price being hit by severe dilution. The second potentially positive scenario is that Bank of America has enough common equity, and doesn't need to convert preferred to common. This would imply that the bank is out of the woods and the discount on the Series L preferreds would likely shrink, as investors bet that the bank can pay the 7.25% dividend. Investors again fled the sector on Monday. But for those able to pick the survivors, preferreds could yet offer preferential returns. Write to Peter Eavis at peter.eavis@wsj.com