Goodbye MIPS,    Welcome Back Real Preferreds
January 30, 2012

In 2003 President Bush lowered the tax on dividends substantially for individual investors. Ironically, just as investor demand for preferred stock would have increased, the supply of preferreds was sparse.

In 1993, the financial engineers at Goldman created a new type of security that was the “holy grail” for issuers: a security that could be considered debt for tax purposes but treated as equity for capital purposes. Texaco issued the first MIPs (Monthly Income Preferred Securities). The name is misleading to investors because the MIPs pay interest, not dividends as they might expect from a preferred stock. The payments are taxed at the maximum rate not the favorable rate available to dividends from “real” preferreds.

Suggested Reading: WSJ Preferred Shares Find Favor Among Banks

The issuance of these “Trust Preferreds” really took off in late 1996 when the Federal Reserve ruled that these securities would constitute Tier 1 Capital to Bank Holding Companies. Between the ruling in mid-October and December 31, 1996, forty banks issued $15 billion in “trust preferreds. 

In 1997 Enron’s VP of finance was quoted as saying  that he was hoping their two recent MIPs issues of $350 million “would allow the company’s rating to be improved from BBB+ to A-“; Enron alone issued $800 million in “trust preferreds”. 

GM offered investors the opportunity to exchange their GM “real” preferreds for “trust preferreds”. So did U.S. Steel, McDonalds, SunAmerica and RJR Nabisco. At least 29 companies issued “trust preferreds” to redeem their “real preferreds”.

By 2003, $211 billion of “trust preferreds” were outstanding. At that time the total of all “preferreds” was only $250 billion; and that total included REIT preferreds that also do not pay “real” dividends taxed at 15%. Today there are only about 100 issuers of “real preferreds”.

A little background on preferreds: 

Preferred stocks are below debt in the event of bankruptcy but are senior in payment to common stock. Preferreds were invented by the financial engineers of the 1800s. The first were issued in Britain to raise funds to complete the Canal system. In 1850, railroads in the U.S. were limited in their borrowing capacity by government mandate. The equity owners did not want more common stock issued that would cause dilution and thus the first preferred stocks were issued in the U.S.

Companies do not get a deduction for payments of dividends on either common or preferred stock. A company that replaced a “real” preferred with a “trust” preferred increased their borrowing cost a bit pre-tax but were now able to deduct the cost, lowering the after tax cost of the offering. Money raised through a debt offering (that has to be paid back) is not good capital, common or preferred stock is. MIPS got the best of both worlds.

Individual investors need to hold “real” preferreds for a minimum of 61 days in order for the dividend to be “qualified” for the reduced tax rate. Individual investors who borrow to finance the purchase of preferreds are allowed to deduct any interest expense incurred to carry the preferreds. Interestingly, corporations cannot deduct interest used to carry dividend paying stocks similar to the prohibition on investor’s ability to deduct interest incurred to carry tax-free muni bonds. The leveraged purchase of a high quality preferred stock paying a tax-favored stream of income financed by deductible interest expense could offer an attractive after-tax return to individual investors.

The Dodd-Frank legislation has effectively changed the landscape. Dodd-Frank phases out the ability for companies to treat “trust preferreds” as good Tier 1 capital starting in 2013. These companies must find other ways to increase their regulatory capital base.

Huntington Bancshares recently offered to exchange their “trust preferreds” for “real” preferreds reversing the process started in 1993. The money raised from these “real” preferreds will constitute good capital under both Dodd-Frank and Basel III. We hope this is the first of many exchange offers/refinancings. Ironically, the supply of preferreds might increase just when the Bush tax cuts expire and the tax on dividends skyrockets to 43.4% from 15%.

Investors should be aware that investments in preferred stocks entail risk. Investors should carefully consider these risks before investing in any preferred stocks.

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