PMT: Before The Market Catches On

• PMT claimed they would turn their fixed-to-floating shares into fixed-to-fixed shares. They were woefully unprepared.

• CIM already came out supporting our interpretation of a very similar prospectus with CIM-B. TWO is keeping quiet but will probably follow PMT.

• There are three categories for LIBOR contracts under the rules from the Federal Reserve Board. We can tell where PMT should land, which tells us which rules apply to them.

• Voices arguing that PMT is right have failed to provide any meaningful evidence for their position. The evidence is overwhelming. It all supports floating rates.

• Regardless of which path we follow for PMT, it ends in their defeat. The only chance I see for them to remain fixed is to avoid having any judge or regulator inspect their decision.

Article Starts

One of my ongoing projects has been evaluating the risk/reward profiles for the preferred shares. To that end, I’ve continued to look into shares where there is greater uncertainty about the future status. These are shares that should be “fixed-to-floating”, but management is (or was) interested in finding ways to keep the shares at a fixed-rate dividend.

Specifically, we’re talking about:

PMT-A (PMT.PA) (PMT.PR.A)

PMT-B (PMT.PB) (PMT.PR.B)

CIM-B (CIM.PB) (CIM.PR.B) (now confirmed as Fixed-to-Floating)

TWO-A (TWO.PA) (TWO.PR.A)

TWO-B (TWO.PB) (TWO.PR.B)

It’s the first 3 shares that really have my attention. The preferred shares from Two Harbors (TWO) are part of the group but less interesting to me as the floating dates are so far away.

Note: If we cover a share and it isn’t in that list, we’ve already determined that this specific risk doesn’t appear to be relevant to those shares.

Note 2: This article was started before the CIM-B announcement. The article is big and deep. I apologize for the length. My first goal is precision. Being concise comes secondary. 

Disclosure

I’ve already prepared several articles on the shares. However, I keep coming back to the logic. My views have changed some, but not all that much. As a reminder, I am not a lawyer or a judge. I have never practiced law nor studied law in a structured setting. I am simply an analyst looking at the terms of investments. This article only expresses my opinion.

Chimera Investment (CIM) validated much of the work in this article. They validated it by filing the 8-k for CIM-B. Specifically, the 8-k indicated that CIM-B was already automatically transitioning to using SOFR + the spread adjustment.

Almost The Same

There are two sources I’m using to determine the rules.

The United States government posted the law according to house.gov.

Note: Cornell also hosts a version of the law, but I find the document from house.gov easier to navigate.

The Federal Reserve posted the final rule: Regulations Implementing the Adjustable Interest Rate (LIBOR) Act.

In theory, these two should indicate the exact same thing. Any differences would just be clarifications providing greater detail. In practice, the wording may be different. That can be a problem. 

You can verify that there are flaws by going to the “sources” section in the Federal Reserve’s final rule. Many of the links are broken. They relied on directing links through govinfo.gov. Unfortunately, that site doesn’t work well (if at all).

There are other issues as well. I will go to great lengths to point some of them out.

Both Valid Sources

I believe courts will have the right to enforce any clause from either source. 

Defining some terms:

• “The law” refers to the first source, written by Congress.

• “The regulation” or “the rule” refers to the second source, written by the Federal Reserve.

A Moment to Complain

I strive to transmit information clearly. The information I transmit may be positive or negative. However, it must be clear. This standard should be applied more frequently. It would dramatically simplify reading the law. More transparent laws should be a goal (but it doesn’t appear to be).

This job (reviewing the law) could’ve been much easier if anyone involved had committed to the following ideas:

1. Tables are better than walls of text.

2. Sentences with more than 2 commas are bad.

3. No document should be published with more commas than periods.

Ernest Hemingway was an author. He won the Nobel Prize in literature. He wrote books with an average of just over 10 words per sentence. Short sentences reduce confusion. They are particularly important for complex topics and large amounts of money.

Complexity compounds. When we have differences between the law and the regulations, those long sentences become even worse.

I believe that PennyMac Mortgage Trust (PMT) misunderstood the law. I believe better writing could have prevented that confusion.

Three Categories

The Federal Reserve decided: “The LIBOR Act broadly distinguishes between three categories of LIBOR contracts with different types of fallback provisions.”

This concept of “three categories” simplifies the process. Since they are part of the regulation (though not in the law), we will use them.

Here’s a quick table for easy reference:

Note: The “Fallback Provision Not Based on LIBOR” will get more nuanced. This will be critical.

This table covers all possible scenarios. However, they are not mutually exclusive. A contract might have:

1. A Determining Person AND

2. A non-LIBOR option 

That contract would fit in categories 1 or 3. Thankfully, that doesn’t appear to be an issue for the shares we cover. It appears that the rule is probably intended to slot the contract into the first category that matches them, but this wasn’t clarified properly.  

Note: It would’ve been better to create a fourth category and make them mutually exclusive. Even if the outcome were identical between the two categories, it would make the process quicker by reducing the potential for conflict.

For our purposes, the “contract” and the “shares” are the same. Each share has a specific contract (in the prospectus). The share and contract cannot be separated. Therefore, the share falls into whichever category the contract falls into.

Note: This article comes in at over 4,300 words, not including those in images. The rest is going to be behind the paywall.