The Pitfalls For Investors With Portfolios Overly Concentrated In Preferred Shares
The basic principle of investing relies on it: diversification. In almost every instance, but especially during times of market turmoil, a diversified investment portfolio serves as a prerequisite to help limit risks and mitigate potential losses for investors. Unfortunately for those who have gone the other investing route, the lesson learned can be costly - and one that many investors are now discovering as they face severe financial losses as a result of portfolios overly concentrated in one type of investment.
A prime example is an investor’s whose portfolio is heavy in preferred stocks only. Bought and sold like common stocks, preferred stocks actually are more similar to bonds. Investors who hold preferred shares means the issuing company pays them any dividends before paying common stock shareholders. In the event a company goes bankrupt, preferred shareholders again move to the front of the line and have first rights to claim the liquidation proceeds of a company’s assets.
At the same time, investors with investment portfolios solely concentrated in preferred shares can open themselves up to significant financial risks. If a portfolio includes investments in several asset sectors versus a single one, the chances that all of those sectors will sustain losses simultaneously is relatively slim. On the other hand, the likelihood an investor might encounter financial losses by holding only one type of security or asset class certainly is not hard to fathom.
In addition, many preferred stocks come with their own set of rules and regulations - both of which can translate into more profits or extra risks.
Stories involving investors who have suffered sizeable financial losses because their brokerage firm over-concentrated their accounts with preferred stocks are becoming more and more visible. Case in point: Freddie Mac and Fannie Mae. On Sept. 8, when the federal government took control of the two mortgage giants to prevent them from going under, investors who had been sold various series of the companies’ preferred shares as “safe, stable fixed-income investments” were shocked to learn the truth. In the week following the takeover by the government, Fannie Mae’s 8.25% preferred stock dropped to $2.65 from $13.70, while Freddie Mac’s 5.57% preferred stock fell to $1.50 from $9.15.
As of late September, investors holding certain series of preferred shares in Freddie Mac and Fannie Mae have seen their investments decline in value by more than 90%. Many of these investors say they were never advised of the risks associated with preferred shares by their brokers. Moreover, some investors were holding preferred shares of Freddie Mac and Fannie Mae as their sole investment, thus leaving the doors of their portfolios wide open for potential financial disaster.
To make matters worse, some investors believed that because Fannie Mae and Freddie Mac were considered “quasi-governmental enterprises,” any defaults on their preferred shares in the companies would be covered by Uncle Sam. They came to that conclusion because that’s what they were told by their brokerage firm.
The fact of the matter is that holders of preferred shares in Fannie Mae or Freddie Mac are in no way covered or protected by the U.S. federal government. Any financial losses these investors sustain are theirs alone.
There are other examples, as well, documenting what can happen to investors whose portfolios are overly concentrated with preferred shares in a single sector or company - from Lehman Brothers’ bankruptcy filing, to the bailout of American International Group Inc. (AIG), to the acquisition of Bears Stearns by JP Morgan Chase at a fire-sale price. As in these and other cases that are coming to light this year, investors who took the advice of their investment bank and bought preferred shares as a “sure bet” and a safe, fixed-income investment are learning an entirely different story as they watch their life savings literally vanish before them.
Our affiliation of securities lawyers is actively involved in advising individual and institutional investors in evaluating their legal options when confronted with subprime and other mortgage-related investment losses.
