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Preferred Securities Update USD Lead Analyst an Abundance of Financial Supply Barry Mcalinden, CFA

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Preferred Securities Update USD Lead Analyst an Abundance of Financial Supply Barry Mcalinden, CFA UBS Wealth Management Research / 19 May 2008 a b Preferred Securities Update USD Lead analyst An abundance of financial supply Barry McAlinden, CFA At a glance Preferred price changes since January 2008 Non-cumulative perpetual preferreds are awarded unrestricted Supply has influenced the performance of each sector. Tier 1 capital treatment by the Federal Reserve and they have 20.0 % played a key role in the capital-raising toolkit of financial institu- 15.0 tions, a trend that is likely to continue. 10.0 We believe the historically high spread levels being offered in the 5.0 marketplace make preferreds an attractive means of expressing a view on the financial sector. We prefer to add exposure to non- 0.0 financial sectors in the corporate bond market, where the dura- -5.0 REIT Preferreds Trust Preferreds tion risk is not as high. -10.0 Non-US QDI Despite the recently improved tone in the credit markets, we con- DRD-Eligible -15.0 Floating-Rate tinue to focus our Outperform preferred security ratings among -20.0 better-positioned financial companies, according to the views of WMR analysts. We believe these companies should continue to Jan-08 Jun-08 Feb-08 Apr-08 Mar-08 experience lesser credit spread volatility and are likely to be less May-08 Source: UBS WMR, as of 16 May 2008 prone to supply-related price pressure. Preferred spreads versus Treasuries Financial preferred spreads peaked in mid-March. Market Overview 500 REIT Preferreds Trust Preferreds It has been a roller coaster ride for the preferred security market as the Sr Note Preferreds 450 interplay between sentiment in the credit markets and new supply Subordianted Note Preferreds Non-US QDI Preferreds have had an influence on prices. After posting exceptional perform- 400 ance in January, prices turned weaker in March as events surrounding 350 the Bear Stearns collapse caused financial stress to peak. Prices again 300 rebounded in April as the Fed’s actions helped to calm widespread credit fears, which caused spreads on risk assets to improve. However, 250 preferreds have since treaded water as an exceptionally active new is- 200 sue calendar continues to take place. This record amount of supply has 150 been the primary factor influencing the preferred market recently as 100 above-average coupons and the massive size of new deals adds pres- Jul- Aug- Sep- Oct- Nov- Dec- Jan- Feb- Mar- Apr- May- Jun- 07 07 07 07 07 07 08 08 08 08 08 08 sure to secondary prices. The areas of the preferred market with lim- ited supply have performed best this year (e.g., REITs, +15 YTD), while Source: UBS WMR, as of 16 May 2008 supply-focused areas have not fared as well (e.g., DRD-eligible preferreds, +2%). 2008 Preferred issuance by structure Type Amount (bn) # Securities What’s fueling the pipeline? Foreign QDI 9.615 5 The hefty pace of preferred issuance comes as a result of the asset Trust 6.310 8 write-downs and de-leveraging that has swept through the entire fi- DRD Eligible 10.936 6 nancial sector. According to Bloomberg, there has been USD 379bn in Subordinated Notes 0.965 3 write-downs worldwide by financial companies, and as a result, USD REIT 0.300 1 262bn in capital has been raised. Financial companies have utilized a Total 28.126 23 variety of methods to help replenish the lost equity capital from the Source: UBS WMR, as of 16 May 2008 balance sheets. This has included both non-convertible and convertible 2008 Preferred issuance by sector perpetual preferred securities and hybrid securities, as well as common equity shares and sovereign wealth funds. Preferred securities have Type Amount (bn) # Securities therefore played a key role in the capital-raising toolkit, a trend that is US banks & brokers 17.496 15 likely to continue. In a Fed speech in Chicago, Fed Chairman Bernanke Non-US banks 9.615 5 Utilities 0.715 2 recently commented that he has been "encouraged by financial insti- REITs 0.300 1 tutions' ability to raise capital and they must be proactive in building Total 28.126 23 up generous cushions.” Source: UBS WMR, as of 16 May 2008 This report has been prepared by UBS Financial Services Inc. (UBS FS). ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 4. UBS Wealth Management Research / 19 May 2008 Regulatory treatment drives issuance Tier 1 capital Among the USD 25 par preferred securities which are the focus of our Non-restricted Tier 1 capital elements coverage, non-cumulative perpetual preferreds have been the most • Non-cumulative perpetual preferred stock (includ- prevalent type of new issue structure. The reason for this stems from ing related surplus) with no maturity date the unrestricted Tier 1 capital treatment that these preferreds are • Common stockholder’s equity, net of Treasury awarded from the Federal Reserve. Cumulative preferreds, on the stock • Minority interests related to common equity or other hand, are subject to a 25% maximum limitation of total Tier 1 non-cumulative perpetual preferred stock capital. At the issuer level, the coupon payments on non-cumulative • Less goodwill, added intangible assets and certain perpetual preferreds are paid on an after-tax basis, and they therefore other items come at a higher cost of capital than trust preferreds that are paid on • Less net unrealized gains on equity securities and net unrealized gains (losses) on available-for-sale a before-tax basis. Trust preferreds, however, are also subject to Tier 1 debt securities. limitations of 15% for internationally active bank holding companies and 25% for other banks. Banks will generally turn to non-cumulative Restricted Tier 1 capital elements (restricted to 25% of total perpetual preferreds once these trust preferred limitations are reached. Tier 1 capital) Although the coupon levels on perpetual preferreds are at high levels • Cumulative perpetual preferred stock not seen since the early part of the decade, the cost is still generally • Minority interest-related to cumulative perpetual lower than issuing common equity and comes without the dilutive ef- preferred stock fects of issuing new common shares. • Minority interest-related common equity or per- petual preferred stock issued by a consolidated subsidiary that is neither a US depository institu- Are non-cumulative preferreds riskier? tion nor a foreign bank. We are often asked about our comfort level with non-cumulative • Trust-preferred securities. preferreds relative to cumulative ones. In the case of coupon deferral, an issuer must repay all skipped payments on its cumulative preferreds, Source: UBS Education Note: Understanding Bank Capital, 26 March 2008 while non-cumulative preferred coupons do not have to be paid in ar- rears. We consider it very unlikely that a solvent financial institution would voluntarily defer payments on its preferred securities as a means Average coupon level for new issue preferreds of conserving capital. Stopping preferred dividends requires elimination New issue coupon levels are at multi-year highs. of common dividends and would cause the company’s funding costs 10.00 and counterparty risks to substantially rise. This would cause operating conditions to deteriorate rapidly and, as a result, it’s only been cases of 9.50 bankruptcy where financials have deferred their preferred dividends. 9.00 Moreover, the credit ratings agencies do not differentiate between 8.50 cumulative and non-cumulative preferreds when assigning ratings to 8.00 preferred securities. In late 2006, Moody’s decided against rating non- 7.50 cumulative preferreds an additional notch lower on the basis that this option is rarely voluntarily exercised by issuers. Rather than basing the 7.00 investment decision solely on the cumulative or non-cumulative feature 6.50 of a preferred, we instead consider the credit quality of the issuer and 6.00 tax status of the security as higher priority inputs into the investment Nov-00 Nov-01 Nov-02 Nov-03 Nov-04 Nov-05 Nov-06 Nov-07 Nov-08 decision process. May-01 May-02 May-03 May-04 May-05 May-06 May-07 May-08 Source: Bloomberg, UBS WMR, as of 16 May 2008 Historical supply has caused dislocations to exist The need for financial institutions to recapitalize has caused various dislocations to occur in the preferred market. First, on a structural ba- sis, the large supply of tax-advantaged preferreds has caused instances where their yields are higher than fully taxable preferreds. This has helped to reduce the legislative risk stemming from change to the divi- dend tax code. Secondly, there are instances where newly preferreds of the same issuer yield close to 100 bps more than issuers’ equal- ranking secondary preferreds. This is due to both the sheer size of many new issues and the above-average coupons that are necessary to clear the market. These dislocations have given investors the opportu- nity to evaluate current holdings relative to other preferred securities that are available with higher coupons and more favorable tax status. Value for the long term Despite having a Neutral view on the Financials Services sector overall, we believe the historically high spread levels being offered in the mar- ketplace make preferreds an attractive means of expressing a view on the sector. Under more normal credit environments, financial institu- Preferred Stock Report 2 UBS Wealth Management Research / 19 May 2008 tions would not be eager to pay up to 400 bps over 30-year Treasuries Issuers with preferreds we rate Outperform in order to issue preferred securities. Instead, these companies have Issuer WMR Senior Debt Credit done so in order to help repair their capital bases during this historical Rating/Trend financial period. The above-average coupon rates would allow the se- curities to perform better than lower-coupon preferreds should interest Bank of America Corp.
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