A TARP Christmas

"I'm dreaming of a TARP Christmas."

That is the Christmas carol ringing in my head. First we had Bank of America repay its TARP funds, then Citi will pay back a portion of its TARP funds. Well Fargo is the latest to announce its TARP repayment. Well will sell approximately $10.4 billion of stock and will repay all $25 billion of government aid. This is in contrast to Citi which will pay back only $20 billion of the $45 billion of aid money it received from the government. The Treasury will also sell up to $5 billion of Citi shares. That would still leave another $20 billion of aid money Citi would have to repay. It also means that the government will continue to have a major ownership stake in the most troubled large bank in the U.S. Baby steps Vikram, baby steps.



Today, JP Morgan came with a sweetheart of a preferred deal. A sweetheart deal for JPM that is. The new preferred will have an initial coupon in the 7.25% to 7.375% areas. That is a fairly low coupon for long term debt. However, it gets better for JPM. After five years the coupon will float off of three-month LIBOR. Typically these deals float 400 or more basis points over three-month LIBOR and have no floor or ceiling. However since Three-month LIBOR cannot go below 0.00%, the effective floor is the spread. Investors and financial advisers became all giddy at the prospect of rising coupons. However, if the coupon rises above where JPM can issue long-term securities, JPM will simply call it away at 25. A flat or inverted yield curve is usually required for such a situation. If the yield curve remains steep and the coupon remains below the trading yield, the preferred will trade at a discount, regardless of how high "rates" rise. Although as long as rates rise one is at least compensated with higher rates while one suffers with a $22 trading price.

The truly negative outcome is for the yield curve to be steep and short-term rates to remain low. That is probably the most likely scenario for 2014. Why do I believe this? Let's look at typical Fed policy cycles. The economy slows, the Fed eases, rates fall, but short-term rates fall more significantly than long-term rates. The economy shows signs of recovery. Inflation expectations cause long-term rates to rise, thereby further steepening the curve. The economic cycle matures and to combat inflation the Fed tightens by raising the Fed Funds rate, moderating inflation pressures casing the curve to flatten. It is often the case that the Fed overshoots resulting in a flat or inverted yield curve. It usually takes a number of years to go through this cycles, often three to five years. This would be perfect timing for this JPM preferred to experience a coupon decline when it begins to float. Floaters DO NOT eliminated interest rate risk for investors. If they did issuers would be exposed to such risk. Floaters are like Las Vegas. Investors can win, but the deals are structured to favor the house (the issuer).

Happy Chanukah and Merry Christmas.