All TruPSed up | FT Alphaville

All TruPSed up

Here’s something suddenly hitting the headlines — the war on TruPS.

That’s Trust Preferred Securities, which have been mentioned on this blog as a major structured finance oops before. And they are now coming under the scrutiny of US regulators.

From Bloomberg:

Congress may end the use of TruPS as capital, forcing banks that issued them to replenish their coffers. Banks are lobbying to remove a provision barring their use that was introduced by Maine Republican Susan Collins and included in the financial reform bill passed by the Senate last month. The Senate version is being reconciled with one passed by the House of Representatives in December that doesn’t include a ban.

The full Bloomberg story is well worth a read, but here’s a quick synopsis.

TruPS are basically a type of preferred security issued by banks and companies. They proved popular among smaller banks since they combined debt and equity characteristics, and came with all sorts of tax and accounting benefits. The securities let firms that issue them defer making interest payments for up to five consecutive years. As of 1996, they also counted towards banks’ Tier 1 regulatory capital.

And here’s where things got messy.

The Federal Reserve allowed TruPS to be treated like capital, but other regulators, like the Office of the Comptroller of the Currency and the FDIC, objected on the grounds they were too weak:

The agency’s view was confirmed during the financial crisis, [FDIC deputy director for policy in the division of supervision and consumer protection George]French said. Banks couldn’t use their TruPS as capital because deferring the dividends would have been seen as weakness, which could have led to bank runs. When payments were deferred, they caused losses for the TruPS held by other banks.

And here’s where things get even messier.

TruPS, it turned out, were great things to stuff into collateralised debt obligations (CDOs). In fact, pooling lots of them together and then tranching them up meant even more TruPS could be issued. For the first time even smaller banks could issue the securities in size. This was in the early 2000s.

TruPS CDOs also meant that banks could effectively invest in each other.

For obvious reasons of concentration risk, current US restrictions require banks to deduct from their capital the full amount of any equity stakes in other banks. But since TruPS ranked somewhere between common stock and debt, they got a much lower capital charge. TruPS CDOs were even better from a capital perspective.

Here’s the breakdown from Bloomberg:

If a bank bought $100 of Citigroup shares, it would have to hold $100 of capital against that asset. The purchase of $100 in Citigroup TruPS would require only $8 of capital. For $100 of AAA rated CDOs that pool bank TruPS, the amount of regulatory capital to be set aside declines to $1.60.

Then the credit crisis hit. Banks started suspending payments on their TruPS, leading to losses at other banks. TruPS CDOs meanwhile, weren’t designed to withstand defaults and deferrals at subprime levels. According to Fitch, default rates on US bank TruPS CDOs went above 13 per cent in April.

So you have a rather wishy-washy form of bank capital — TruPS — in the midst of a financial crisis. Then you’ve got investment by banks in other banks’ wishy-washy capital. And on top of that you have banks investment in TruPS-collateralised CDOs. It’s one big TruPS time bomb:

The suspended payments by issuers caused CDOs to be downgraded by rating firms. When the rating dropped below investment grade, as dozens of them did, the banks’ capital charges against the CDOs could multiply by 60 times

So, the disqualification of TruPS from banks’ regulatory capital (like the war on Deferred Tax Assets) is something we can get behind. Not that it won’t cause one almight headache for banks when it happens.

Moody’s did a little estimate last month:

The credit implications of the Collins Amendment are negative for most, if not all, bank holdcos that have issued trust preferreds including the “big four.” The exhibit below presents Moody’s estimate of the percentage of trust preferreds relative to Tier 1 capital that would be disqualified for regulatory capital purposes:

We expect that all rated bank holdcos would still have sufficient Tier 1 capital after excluding trust preferreds to meet all current regulatory capital requirements and remain well-capitalized. Nonetheless, the exclusion of trust preferreds would clearly erode bank holdcos’ regulatory capital cushions, although the timing for the phase-out of trust preferreds has not been specified and a transition.

Ah well, no pain, no (stability) gain, we always say.

Related links:
In CDOs we TruPS – FT Alphaville
In the Fed we TruPS – FT Alphaville