Also known as TruPS, trust-secured preferred securities were popular issues with bank holding companies until the credit crisis of 2007. TruPS contained features of both debt as well as equity, and can yield more than traditional bonds or preferred stock, making them attractive to investors too.
In this article, we're going to cover the topic of trust-preferred securities. As part of that discussion, we'll talk about the history of these investments, including their role during the credit crunch of 2007. Next, we'll explain how companies go about creating these trusts, and the features typically found with these issues. Finally, we'll review the advantages and disadvantages of these securities from both the corporate as well as investor point of view.
Back in 1996, the Federal Reserve Board permitted bank holding companies to include TruPS as part of their tier 1 capital requirements. As such, they allowed banks to hold a larger value of deposits, expand operations, and increase shareholder return on equity. For income tax purposes, the IRS treats TruPS as debt, which allows issuing companies to deduct interest payments on their tax returns.
A study published by the FDIC in the winter of 2010 contained several important insights concerning the institutions leveraging these issues. The FDIC would eventually conclude that companies issuing TruPS as regulatory capital were financially weaker, willing to take on additional risks, and eventually failed more frequently than banks that did not issue these securities.
TruPS are also associated with the collateralized debt obligation (CDO) market. Many banks did not have the size, or resources, to effectively bring TruPS directly to the market. Instead, these companies would sell their securities into a CDO, where it was pooled together with those of other small companies.
Typically created by large banks, the first step in the process is to create a trust. This trust is then used to hold an asset; usually subordinated junior debt. The trust then issues preferred stock to potential investors. The debt held by the trust would have the same terms as the preferred stock. Essentially, the company connects the provisions of the debt directly to those of the preferred stock. The company would then make interest payments to the trust. Subsequently, the trust makes payments to the holders of its preferred stock.
These securities are typically offered in $25 denominations, and they provide investors with both income as well as a claim to a portion of the trust. The debt held in these trusts normally has maturities of around 30 years. They can offer investors fixed interest rates, floating rates, or a combination of the two.
Interest payments are usually made quarterly, and the debt matures to face value. Like many other issues of bonds and preferred stock, TruPS can be called, or redeemed, prior to maturity.
Trust-preferred securities provide companies with one big advantage relative to issues such as preferred stock. To bank holding companies, TruPS provide a significant second advantage too:
*Note: The Collins Amendment to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (discussed later on), modifies the capital treatment of trust-preferred securities.
Some of the advantages trust-preferred securities offer investors include their high interest rates and long maturities:
In addition to the risks that provide investors with higher yields, reforms following the credit crisis of 2007 results in even more drawbacks to these issues:
In late 2009, the Basel Committee on Banking Supervision (BCBS) published the paper "Enhancing the Resilience of the Financial System." Many of the proposals appearing in that paper were agreed to by the Group of Central Bank Governors and Heads of Supervision. One of the goals of this group was to strengthen the definition of regulatory capital. As part of that reform, the definition of tier 1 capital would phase out TruPS beginning in 2013.
In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was signed by President Obama. Section 171 (also known as the Collins Amendment) provides that tier 1 capital treatment of TruPS issued before May 19,2010 by depository institutions with at least $15 billion in assets will be phased-out during a three-year period starting January 1, 2013.
The likely fallout of these moves will be a further decline in the use of these securities by bank holding companies as well as a decrease in market activity. For the investor, the future of TruPS may hold both limited opportunity as well as greater risk.
About the Author - Trust Preferred Securities or TruPS