Life is full of second chances, sometimes even in investing. In that connection, ING’s (ING) cumulative preferred shares plunged with the shares of the broader financial services community when the financial crisis reached its depths. ING’s 6.2 % perpetual debt securities issued in 2003 with a $25 a share denomination (ISP) reached a low of $3.20 a share this March. Since then ISP had gradually trended up again past $18, until it took a big fall back to the $11-$13 range in August. Other preferred shares originally issued with $25 denominations such as ING’s 7.05% perpetual debt securities (IND) and 8.5 % perpetual hybrid capital securities (IGK) followed the same trend at moderately higher price levels, falling respectively to $14-$15 and $16-$18. The issues yield dividends of 11.75% (ISP), 12.28% (IND), and 12.52% (IGK) at market closing for the week on September 4, 2009.
As far as I can tell, here’s what happened. On March 31, the European Commission (EC) issued a finding temporarily clearing the Dutch government to backup ING’s portfolio of Alt-A mortgages for 6 months.1 Then, on July 22, the EC issued a paper entitled “The return to viability and the assessment of restructuring measures in the financial sector in the current crisis under the state aid rules.”2 In this paper, the Commission stated:
[Page 7] In order to limit distortions of competition and address moral hazard, aid should be limited to the minimum necessary and an appropriate own contribution to restructuring costs should be provided by the aid beneficiary. The company and its capital holders should contribute to the restructuring as much as possible with their own resources. This is necessary to ensure that rescued banks bear adequate responsibility for the consequences of their past behaviour and to create appropriate incentives for their future behavior.
[Page 8] The banks should be able to remunerate capital, also in the form of dividends and coupons on outstanding subordinated debt, out of profits generated by their activities. However, banks should not use State aid to remunerate own funds (equity and subordinated debt) when those activities do not generate sufficient profits. Therefore, in a restructuring context, the discretionary offset of losses (for example by releasing reserves or reducing equity) by beneficiary banks in order to guarantee the payment of dividends and coupons on outstanding subordinated debt, is in principle not compatible with the objective of burden sharing.[Footnote 33] This may need to be balanced with ensuring the refinancing capability of the bank and the exit initiatives.[Footnote 34] In the interests of promoting refinancing by the beneficiary bank, the Commission may favourably regard the payment of coupons on newly issued hybrid capital instruments with greater seniority over existing subordinated debt. In any case, banks’ [sic] should not normally be allowed to purchase their own shares during the restructuring phase.
[Page 8] Footnote 33 provided: [citation to unpublished decision omitted] However, this does not prevent the bank from making coupon payments when it is under a binding obligation to do so.
[Page 8] Footnote 34 provided: See Impaired Asset Communication, point 31, and the nuanced approach to dividend restrictions in the Recapitalisation Communication, points 33, 34, and 45, reflecting that although temporary dividend or coupon bans may retain capital within the bank and increase the capital cushion and hence improve the solvency of the bank, they may equally impede the bank’s access to private finance sources, or at least increase the cost of new future financing.
Nothing in the text of the Commission’s paper itself is alarming. The idea of modifying capital structure to pay dividends while sustaining huge operating losses and receiving government aid to keep a financial institution afloat is basically a sham, and it’s no surprise that governments don’t like it. But as recognized by footnote 34, this strategy may be necessary for an institution to retain access to capital markets since once dividend or coupon payments on hybrid or debt instruments are suspended, its credit ratings crash.
As demonstrated by the CIT (CIT) experience on the eastern side of the Atlantic—where the company paid its preferred dividends after receiving $2.3 billion in TARP aid from the U.S. Government despite turning only one profitable quarter in two years—this strategy can be a disaster for investors when the company appears to lack a viable strategy to recover. But there has been no such indication that ING’s condition is anything close to CIT’s “on life support” predicament. ING recently reported a small profit of $.04 a depository share for the second quarter of 2009 following three quarters of losses concentrated in the 4th quarter crisis epicenter. Even after the release of the EC’s communication, the prices of ING’s common and preferred shares continued to rise through early August.
What turned the tide was a decision on August 20 by credit ratings agencies Moody’s and Fitch to cut the ratings of ING’s hybrid debt. The decision was connected in particular to KBC, a Belgian bank, halting its payments of preferred dividends in response to the pressure of EC regulators, raising the possibility that ING would be forced to do the same.3
A comparison of KBC to ING may not be entirely fair. Having received its third bailout in May4, KBC’s case—at least form a public relations perspective—may be more akin to chronic/multiple bailout brethren Citigroup (C) and AIG (AIG). Also, ING appears to have a head start at raising capital by selling assets, as reflected by recent reports that its sale of its Swiss and Asian private banking assets is on track.5
I’ve argued that investors can make money by identifying an instance where Wall Street’s misunderstands public policy (see my post How to Make Money in Stock by Arbitraging Wall Street’s Misunderstanding of Public Policy), and this may be an instance of such an opportunity with a European flair. The policy standard articulated by the European Commission is rational on its face, and did not by own terms turn the market against ING’s preferred shares. Moreover, with KBC’s triple bailout status and the American experience of CIT paying preferred shareholders after receiving government aid and then begging for more fresh on regulators minds, it’s not surprising that the Commission pushed KBC to stop the payments.
With a an arguably less motley bailout history (a EUR 10 billion cash injection in October 2008 and a backup facility for Alt-A mortgages announced in January 2009),6 and asset sales proceeding at a respectable pace, the Commission may be reluctant to upset ING’s applecart. So there’s a good argument that the credit agencies and market have overestimated the risk that ING will suspend the payments.
But it’s not inconceivable that the credit agencies will be right, and the Royal Bank Of Scotland’s decision not to call $1.6 billion of subordinated bonds because of regulators’ objections may reflect an acceleration of this trend.7 If they are and the dividends are suspended, the stock price will probably go down more, though it’s possible that most of the decline from halting the dividends is already priced in.
Trying to figure out what the regulators will do is guesswork. What seems far more predictable, however, is that ING will recover, so that the share prices will eventually trend back up towards their $25 par value. Either ING will pay preferred dividends without interruption, or it will halt them if the Commission presses the issue and pay up later—including the missed payments with interest for the cumulative preferreds.8 If these scenarios play out, patient investors who buy now will likely make money down the line, though possibly with a short-term decline if the dividends are deferred. Another strategy is to hold out to see if they defer the dividends, but if they don’t the share price may jump and the opportunity will be lost. A middle of the road option would be to decide the maximum to invest, put half in now, and put the other half in later if the stock price goes down due to dividends being suspended.
My own sentiment is that one of the two above scenarios will happen. ING is a conglomeration of traditional European and modern mass-marketed financial services that has returned to profitability and is not likely to go under. Its on-line banking platform, ING Direct, has become a mature on-line financial services operation that is effectively marketed with a contemporary orange ball alongside ING’s venerable orange lion.9 ING has recently deployed its captivating “find your number” campaign to draw consumers into its retirement oriented financial services.
There are arguments that ING’s earning prospects have been abridged by deleveraging. But even if true those theories are a far cry from establishing that ING will not be a stable and profitable concern. Remember, we’re talking about preferred stocks that pay a fixed dividend—and are required to do so if any dividend is paid on common shares—not common shares that will respond to the potential for higher dividends. The idea is to establish that the business is stable for the long term to get the share price back to par and keep the dividends coming.
Interested? Investing in preferred shares is a complicated business that can depend on the terms of the individual issue, so you’ll want to take a close look. Fortunately, the prospectuses for ING preferred issues are accessible on-line on ING’s web page at http://www.ing.com/group/showdoc.jsp?docid=075252_EN&menopt=ivr%7Cfis.
Disclosure: The author is long on ING ADR’s (ING), ING 6.2 % preferred perpetual securities (ISP), and CIT preferred Series A (CIT.PR.A) as of the original publication date of this post. The author does not hold a securities position in CIT common shares or in any issue of KBC Group (KBCSY).
- “State aid: Commission temporarily authorizes illiquid asset facility for ING, March 31, 2009, at http://docs.google.com/gview?a=v&q=cache:USBKvXaGGvkJ:europa.eu/rapid/pressReleasesAction.do%3Freference%3DIP/09/514%26format%3DPDF%26aged%3D0%26language%3DEN%26guiLanguage%3Den+ing+european+commission+burden+shairing&hl=en&gl=us [↩]
- Commission Communication: The return to viability and the assessment of restructuring measures in the financial sector in the current crisis under the State aid rules, July 22, 2009, at http://docs.google.com/gviewa=v&q=cache:pgxQ41T8Ie8J:ec.europa.eu/competition/state_aid/legislation/restructuring_paper_en.pdf+July+European+commission+bank+restrucrturing+burden+sharing&hl=en&gl=us . [↩]
- “Fitch cuts European bank hybrid debt ratings,” Reuters UK, August 20, 2009, at http://uk.reuters.com/article/idUKN2042464020090820. [↩]
- “Belgium Moves onto Crisis Mode on KBC Bailout,” The Wall Street Journal, May 15, 2009, http://online.wsj.com/article/SB124225248484816987.html [↩]
- See “UPDATE: HSBC Bids for ING Private Banking Asserts-Source,” The Wall Street Journal, September 4, 2009, at http://online.wsj.com/article/BT-CO-20090904-704808.html. [↩]
- “Transactions with Dutch State,” at http://www.ing.com/group/showdoc.jsp?docid=363620_EN&menopt=ivr|tdt&menopt=ivr|tdt [↩]
- “RBS Told Not to Call Subordinated Bonds After Bailout,” Bloomberg.com, September 4, 2009, http://www.bloomberg.com/apps/news?pid=20601087&sid=afiEP8f7OhaA.” [↩]
- Investors should review the prospectuses to fully understand the conditions concerning the payment of cumulative interest, including extraordinary situations where cumulative interest or payments would not be made. [↩]
- See “The history of the ING Lion,” at http://www.ing.com/group/showdoc.jsp?docid=168408_EN&menopt=abo%7Chis%7Chil. [↩]