Preferred Stock Paper

5125 Words Mar 26th, 2014 21 Pages
The Risks of Preferred Stock Portfolios
SLCG Working Paper 1
Abstract Preferred stocks are a hybrid of debt and equity. In this paper, we examine preferred stocks with an emphasis on the risks of holding portfolios of preferred stocks. We demonstrate that preferred stocks are similar to debt when the issuing company is financially healthy, and become more similar to equity when the company’s financial condition deteriorates. We show that issuers of preferred stocks are heavily concentrated in the financial services industry, a fact that exposes investors who hold a portfolio concentrated in preferred stocks to further risk - industry concentration risk. We illustrate the features of preferred stocks using the Fannie Mae 2008 issuance as
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Figure 2: Total Offering Value of Preferred Stocks Issued, 1994-2009.
This figure presents the amount in billions of dollars of new public issuances of preferred stocks between 1994 and 2009 for the financial and the non-financial sectors. $200 $180 $160 $140 Billion $120 $100 $80 $60 $40 $20 $0

Financial Sector Non-Financial Sector

The Federal Reserve requires banks to maintain a certain level of permanent capital, or “Tier 1” capital, to control banks’ risk profiles and thus protect investors and the banks’ depositors. This permanent capital is essentially equity capital since its holders do not have the right to demand periodic payments or repayment of any principal or face value. In 1996, the US Federal Reserve ruled that non-redeemable, non-cumulative preferred stock could be used to meet banks’ capital requirements. 2

2

See for example Bentson, Irvine, Rosenfeld, and Sinkey (2003).

Securities Litigation and Consulting Group, Inc. © 2010.

4 Today, Tier 1 capital includes common stock, retained earnings and non-cumulative, non-redeemable preferred stock. In addition to banks, other financial institutions issue significant amounts of preferred stocks. For example, in 2007 Freddie Mac and Fannie Mae raised
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