Given the damage to investor confidence and the fear in the market, a relatively safe category of financial instruments are now yielding an excellent return.

This category of financial instruments are the preferred stocks of publicly traded firms. Firms and especially banks issue preferred stock to investors in order to bolster their capital without having to issue additional common stock and hence diluting the value of common stock.These preferred stocks are either perpetual or may be redeemed by the issuing firm after a few years.  There are a lot of other wrinkles that preferred stocks have (like being convertible to common stock etc ) which are not relevant to the current discussion.

The upside for investors in preferred stock is that they are provided with dividends at a fixed/agreed upon coupon rate and these dividends have to be paid ahead of paying any dividend to the holders of common stock. The downside is that preferred stock does not usually appreciate in value similar to common stock. Preferred stock are traded on an exchange much like common stock and have more in common to bonds than to stocks.

Warren Buffett’s recent investment in preferred stock of Goldman Sachs and GE at a coupon rate of 10% has brought these instruments to the spotlight.

While the average investor may not get the same opportunity with Goldman or GE , there are other opportunities out there in the market due to the battering that preferred stocks have received (warranted or not) along with regular common stocks.

Risk and Reward

There are a few risks associated with preferred stocks :

- If the firm goes into bankruptcy, like common stock, they stand in line after creditors. However they get paid before any payments to common stock holders

- If a firm is in dire straits and if it does not pay dividend at all, unlike bond holders, preferred stock holders won’t get paid

These risks are out weighed by

- The tax benefits compared to bonds – these dividends are taxed at the lower 15% capital gains tax rate

- The materially higher dividends paid when compared to common stock and also the relatively stable preferred stock price when compared to common stock price

How to find the right preferred stock to invest in

The site www.quantumonline.com lists most of the traded preferred stocks that are eligible for the 15% dividend tax rate along with their coupon rate. This can be a launch point for your analysis.

There are a few preferred stocks that currently stand out based on their yield and their issuing firms ability to stay solvent in this turbulent environment – either due to the US Government implicit guarantee (Bank of America and JP Morgan) or due to excellent capital structures (HSBC and Allianz)

- HSBC (ticker -HCS) : Based on the current stock price, it yields 9.8%

- Allianz (ticker – AZM) : Based on the current stock price, it yields11.1%

- Bank of America (ticker – BAC-H): Based on the current stock price, it yields 9.07%

- JP Morgan (ticker – JPM-I): Based on the current stock price, it yields 8.6%

These are now worth looking at as a less risky (than common stocks) alternate to investing in bonds or staying in Cash.

Note : No asset class is safe these days with all kinds of  financial instruments which nobody realized existed getting into distress territory due to extreme fear and large out flows from them. The safest asset in the intermediate term seems to be US $ (not even gold) as no country/central bank holding it can afford to exit it without causing irrepairable self damage.

‘Peer to Peer lending’ is a loose term for individual lenders lending directly to borrowers with minimal involvement from intermediaries. This can be contrasted with the typical lending process where you place your deposits with banks or other such institutions which in turn lend to borrowers of their choice. In the typical lending process depositors don’t know who the borrowers are.

‘Prosper’ is the biggest player in this nascent ‘Peer to Peer lending’ space. It’s loan portfolio is still tiny compared to a bank and the track record is just beginning to take shape (earliest loans are dated June 2006).

Key features of Prosper

• Loans are unsecured and not FDIC insured
• Standard loan period of 3 years
• Borrowers are categorized into Credit grades of AA (760+), A (720-759), B(680-719), C(640-679), D(600-639), E (560-599)and HR (520-559). Credit scores are from Experian.
• You can automatically distribute your loan amount amongst a set of borrowers to reduce risk
• Delinquent loans are turned over to a collection agency which charges standard recovery commissions
• Prosper makes money by collecting fees from both lenders and borrowers

Given the intriguing nature of ‘Peer to Peer lending’ , I decided to do a bit of digging on how ‘Prosper’ loans pan out as an investment option. Here are some findings :

Typical Interest rates

Here are rates ( during the last 30 days) for loans between $1000- $5000. (Taken from Prosper website)

AA 7.65%
A 10.01%
B 14.32%
C 15.10%
D 21.60%
E 27.52%

Delinquency

I found a blog “Fred’s” that used Prosper’s own data (provided on its performance page) to do an analysis on how the age of a loan affects its delinquency behaviour.

This is quite an important analysis as loans recently originated are usually less likely to be 1+ month delinquent compared to older loans. The problem is more severe as Prosper’s performance reports usually mix the performance of new and old loans and thus make it difficult to judge loan behaviour over time.

The above chart (taken from Fred’s blog) shows the following for loans originated in any one month – % of loans that are 1+ month late Vs the number of elapsed days from the loan origination month. Interpreting data for one particular month – say June ‘06, it shows that 10% of loans for that month went delinquent after 180 days (from June ‘06) and 19% of loans for that month went delinquent after 360 days (from June ‘06)

Note that the curves show the same pattern across months and on average 16-24% of loans become delinquent 360 days from when they are originated. This is a staggering rate.

However, it is very important to note that this analysis is across all credit categories.

In order to analyze delinquency by credit category, I took a snap shot of Mar ‘07 loans’ performance data from Prosper website and the situation improves dramatically for AA and A categories.

AA loans – 1+ delinquency rate is 3.55% by value and 1.11% by number of loans

A loans – 1+ delinquency rate is 12.58% by value and 6.02% by number of loans

As you can see, this is a far cry from the 16-24% one year delinquency rate across all credit categories.

Collection agency effectiveness

The record is quite dismal in this respect. Over the last 3 months, their largest collection agency by volume of delinquent loans sent to it (‘Amsher’) has collected only 8.47% of the dollar value sent to it for collections for AA and A borrowers and the % collected falls of to 3.92% for B-D borrowers.

Since loans are sent to the collection agency just one month after they are past due, the above recovery percentages are quite dismal and it means that once a loan goes delinquent there is little chance of getting your money back.

Sale of distressed debt

If loans stay uncollected for 3 months with the collection agency, the loans are sold to a distressed debt buyer. The metrics for the last such sale by prosper yielded 9.6% of principal amount for AA and A borrowers debt. The trend from Prosper’s metrics over the last year shows that distressed debt buyers are paying less and less of the principal which may be a reflection of the current economic environment and the general risk aversion to less than perfect debt.

Summary

It may pay to lend to AA borrowers as long as you spread your loan across a wide set of borrowers. I would not suggest lending to any other credit grades till Prosper tighten’s up borrower verification and collections effectiveness.

I have recently created a portfolio with my stock picks. The intent like most mutual funds out there is to beat the indices – particularly the S&P 500.  Specifically in this case, the intent is to come out ahead of the S&P 500 by a decent margin by the end of 2009.

As an experiment, I have posted the portfolio holdings and its NAV (Net Asset Value) on this website under  ”My Stock Portfolio“. I will be updating the holdings and the NAV on a monthly basis.  Readers of this blog will have a chance to track the portfolio performance and make decisions for their own portfolios.

Note that this is an experiment and may be discontinued if personal or other situations  demand it.

If you think, as an individual investor, you have no exposure to the sub-prime arena and hence your investments are safe , you are wrong.

The turmoil in the stock markets over the last week are but one manifestation of the far reaching implications of the problems in the sub-prime space. It is a perfect example of financial wizardry gone wrong and the butterfly effect.

The following analysis uses as input, the thoughts, ideas and opinions stated by various experts in the field including the Wall Street Journal and the Time magazine.

The start of easy credit – Everybody gets approved for a Home loan

During the period of 2002/2003, when stock market returns were low and the interest rates were also low, financial institutions started looking out for new avenues to improve their returns which had started looking anemic.

Wall Street had just the vehicle they wanted – securitization and the creation of exotic financial instruments / derivatives (i.e those financial instruments that derive their value from another underlying variable/asset)

Securitization turned loans that sat on banks books into securities that can be sold in the global markets. It involves the sale of the loan by the lender to a new owner–the issuer–who then sells securities to investors. The investors are buying “bonds” that entitle them to a share of the cash paid by the borrowers on their mortgages

Here comes the Financial Alchemy / Wizardry /Naiveté / (Fraud ..shhh)

Wall Street took this practice a step further by packaging bigger pools of securities into collateralized debt obligations, or CDOs. With CDOs, you package a bunch of low-rated debt like sub-prime mortgages and then break the package into pieces, called tranches based on the level of risk/return.

The alchemy begins when rating agencies such as Standard & Poor’s and Moody’s wave their magic wand over the top tranches and declare them to be a top notch AAA rate. This opened up this market for traditionally conservative investors such as commercial banks, insurance companies and pension funds

So, there you go – you have an army of investors willing to buy these ‘triple washed’ mortgage backed securities and banks/mortgage lenders willing to supply the sub-prime loans to Wall Street which converted them into these securities for a hefty profit. The home buyers also benefited with many getting loans they otherwise would never have.

Alas, abnormally good times don’t last long

The tide turned when home prices started stalling and even going south. The sub-prime borrowers who kept postponing the day of reckoning by refinancing their appreciating homes could no longer continue to do so. And the defaults started.

The Dominos are starting to fall

The first to be affected when things started going south were the sub-prime lenders and those who bought vast quantities of these junk instruments. These included hedge funds like the two Bear sterns funds that blew up – ‘High Grade Structured Credit Strategies Enhanced Leverage Fund’ and ‘High Grade Structured Credit Strategies Fund’. (Note the words ‘Structured Credit’ and ‘Leveraged’)
The domino effect has just started. The last few days of gyrations in the stock market are indications that the contagion has spread. The reason is the tight linkages between the various markets via the players who straddle these different markets.

A number of hedge funds are failing and the key reason is the extremely high leverage they carry. For anybody who has used margin money while purchasing / selling stocks, the concept of leverage should be very clear. For example, a 10 to 1 leverage implies $10 of position with $1 of funds in the account.

As things started to go south for highly leveraged funds holding the sub-prime securities, they started facing margin calls and since nobody is willing to buy sub prime assets, they started selling those assets which can be sold, thus depressing the value of even the non sub-prime assets which can include stock and other securities that are completely unrelated to the sub-prime problem area. This now triggers a fresh set of margin calls for hedge funds who hold these non-sub prime assets as the value of their portfolio erodes. The cycle of blood bath thus continues.

Only the future will tell how this will end and how much of the financial market turmoil will translate to the economy. What is certain however is that we have not seen the bottom of this Gorge.