Should Optimal investors have a Preference?

Santander has proposed a settlement to its Private Banking clients (it is not clear whether this applies to clients who owned Optimal products through other accounts). It is supposedly “for the principal amount invested, net of redemptions, in Optimal Strategic, which amounts to 1,380 million euros“. Returning investors’ original investments, albeit without compensating for interest foregone over the years, the fact that clients would have been relying on a certain value of their investment and the stress caused by the whole affair, would appear to be at least a starting point.

At a closer look, Santander is once again trying to scam its clients. What it actually proposes to do is to give them “preferred securities to be issued by the Group in the referred amount  of 1,380  million euros.  These preferred  securities will have an annual coupon of 2% and a Santander Group call from year 10. “

Preferred securities are a half way house between equity and bonds. If a company goes bust, the bond holders have first claim on the assets. If anything is left over (in the case of a bank, very unlikely), preferred shareholders get something back. If anything else is still left, equity holders might get something. So what are these 2% preferred shares worth?

Santander has the option to call the securities in 10 years time (ie repay the full amount). It does not have to do this and in fact is unlikely to, as funding at 2% is very attractive for the bank. If the securities were to be repaid in 2019, they should yield more than a 10 year bond (as they are riskier). Santander bonds maturing in May 2019 yield 8.8%. Santander equity has a dividend yield of 10.6%. So the preferred shares would need to have a yield of around 10% to be in line with the market, meaning they would need to trade at 50% of their face value (the amount Santander claims to be paying out) today.

In fact, Santander has plenty of preferred securities outstanding and they are only repayable in 2049 (as is fairly standard in the banking world). It is very likely that these would take the same form. There is no active market for them, although occasionally someone makes an indication in prices. The latest indications seen in the market imply yields to maturity of around 14% (based on 7.35% prefs maturing in 2049). On that basis, the 2% preferreds should be worth just under 15% of their face value. This is the most that an investor could hope to realise today from a sale of such securities, assuming he even found a buyer (very unlikely if you are a private client). Given you cannot sell them, you have to be a very patient (and young) investor to wait 40 years for redemption.

When we read on, Santander admits that “the pre-tax  cost for  the  Group of  this  transaction would  be  500 million euros, which has been fully-booked against the accounts for 2008“. So while Santander claims to be offering clients E1,380m in compensation, it is in fact only taking a charge of 36% of that amount (roughly in the middle of the market-derived 15-50% range). Although we have yet to see the exact terms of these prefered securities, I suspect the 36% is a conservative writedown for Santander, which they expect to reverse over time given the very low value of the securities they are proposing to issue (around E200m based on 15%). It is also almost certainly less than they have taken in fees from their Madoff victims over the last 10 years.

Many investors may be relieved that they are being offered something back. If they are not financially sophisticated, they might even believe they are getting a full refund. However I suspect most will correctly understand this offer as adding insult to injury by Santander. In that light, the lawsuit launched yesterday in Florida looks like a far more attractive option. Anyone who accepts the near worthless preferred securities loses the right to sue – be warned!

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