Who uses preferred stock?

In my last post, I made the argument that preferred stock is very expensive debt. To give you a sense of the differences in costs between the different types of financing, consider a company like GE that has common stock, preferred stock and conventional debt outstanding. In March 2009, the cost of equity was close to 12%, the preferred dividend yield was about 9-10% and the pre-tax cost of debt was about 6-7%. On an after-tax basis, the pre-tax cost of debt was closer to 4%.

To understand why firms use preferred stock, given its high cost, we have to look at the two groups of firms that are its biggest users - financial service firms and young, growth companies.

1. With financial service firms, the allure comes from the way regulatory authorities define equity capital for capital ratios. They generally include preferred stock in equity. Thus, preferred stock may be considered expensive debt that gets treated as regulatory equity - a big bonus for firms that get judged based upon their capital ratios. (To add to the problem, ratings agencies also seem to treat preferred dividends as quasi-equity... giving higher ratings to these firms than they truly deserve, given their cash flow obligations).

2. With young, growth companies and some distressed companies, there is a different reason. Since these firms are often losing money, debt does not provide a tax advantage anyway. From, the firm's perspective the difference in costs between debt and preferred stock narrows, as a consequence. From the investors' perspective, the allure of preferred stock is that it is generally cumulative (dividends not paid have to be made up for in future years) and convertible to common stock. Thus, the investors, while running the risk of not receiving preferred dividends during the bad years, get priority in claims to cash flows (if the company starts making money) and can use the conversion option, if the firm's market value also climbs.

If nothing else, the existence of preferred stock is a testimonial to the effects that regulatory and tax laws have on financing choices. Bad laws (and regulatory definitions) will create bad financing choices. We may be seeing this play out in the current crisis. In my view, banks, insurance companies and investment banks that faced capital constraints would have been better off raising common equity early in this crisis rather than go for preferred stock from unconventional sources. Even those banks that thought they were getting a good deals on preferred stock (from the government) are discovering that there are implicit costs in these deals.