Actually no. Banks have numerous sources of cash to lend. They can issue term securities (bonds). They can borrow from other banks. They can take deposits. They can borrow from the BOC. All this has to be backed by capital. The big Canadian banks are all trying to maintain a 10% tier-1 capital ratio. And these new pref shares are tier-1 capital. So for every dollar of these issues, they can lend $10, with the cash to do so coming from a variety of sources. They make their money on the spread between their blended cost of capital and their overall lending rate. Equity (pref or common) is their most expensive capital.

Today’s Wall Street Journal contained a brief mention of preferred stocks, with a suggestion that “Tax-savvy investors looking for nice returns amid the credit crunch may find an answer in a gusher of preferred stocks now issuing from financial firms. Yields on these bond-like securities are so high, and the taxes so low, that bond managers say preferred stock is a nice complement to municipal bonds.” A number of financial firms have recently issued such securities in an effort to shore up their wobbly balance sheets, often pricing a $25-par issue with a fixed-rate dividend to yield 8%. The article suggested this “window of opportunity” might last only a matter of months.

Meanwhile, the most recent issue of the Journal’s sister publication Barron’s cites a prominent money manager who takes a somewhat darker view of the situation. At a recent institutional research conference, a veteran investor in distressed securities found little to like among these preferred stock issues despite the promise of such generous dividends. “They have nowhere to go but down,” he observed. “They can go up $1 or down $25.” A successful hedge fund manager interviewed in the same issue of Barron’s believes subprime mortgages represent only a small portion of the banking industry but construction lending is a “core product,” and he is making a major bet that loan losses in this sector will become “a big problem.”

We have no idea if these hedge fund sharpies will be proved right or wrong, and have no opinion on the outlook for preferred stocks, high-yield or otherwise. If forced to make a prediction, we suspect most of these issues will pay their promised dividends while exhibiting an acceptable level of share price fluctuation. But it would not be surprising to find one or two that eventually spring a leak, and we can only hope that anyone holding such positions did not view them as substitutes for low-risk fixed income vehicles. The ink is barely dry on articles discussing widespread disappointment with billions in now-illiquid auction rate securities, so investors have little excuse for assuming that markets are offering high yields with little risk. As Bear Stearns shareholders discovered to their dismay two months ago, a sudden shift in investor confidence can be a swift death sentence for a financial institution. In such cases, holding a “preferred” stock with senior status among equity claimants may be the equivalent of clutching a deck chair one row closer to the taffrail of the Titanic.

In fairness to the Wall Street Journal, the article concluded with the following observation from a financial planning representative at the Schwab Center for Financial Planning: “If the preferred stock yield seems too good to be true, it probably is.” Good advice.

Dale, Arden. “If Thinking of Preferred Stock.” Wall Street Journal, May 27, 2008.
Bary, Andrew. “The Best, from the Brightest.” Barron’s, May 26, 2008.
Strauss, Lawrence C. “Where the Financial Crisis Is Headed Next.” Barron’s, May 26, 2008.
Rappaport, Liz. “Auction-Rate Securities Give Firms Grief.” Wall Street Journal, May 27, 2008.

Weston J. Wellington, Vice President, Dimensional Fund Advisors