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SRC Insights: First Quarter 2009

Emerging Issues Regarding Trust Preferred Securities

On October 21, 1996, the Federal Reserve Board approved—with limitations—bank holding companies (BHCs) to include certain cumulative preferred stock instruments in tier 1 capital. These instruments, commonly called trust preferred securities, or TPS, are considered hybrid securities because they contain features of both debt and equity. TPS provide bank holding companies with a means to raise capital for regulatory purposes and deduct the interest payments on the corresponding subordinated debt for tax purposes. Such advantages have made TPS a very popular vehicle for raising capital throughout the past decade, and the advent of pooling and private placements of TPS has opened this market to smaller community BHCs. This article will examine the capital treatment effective as of March 2009 and discuss emerging supervisory and other related issues.

A Recent History of TPS

As of December 31, 2008, almost 1,400 bank holding companies had approximately $148.8 billion in outstanding TPS,1 compared to 110 BHCs with $31.0 billion outstanding in 1999.2 As of year-end 2008, 30 of the 101 BHCs in the Third District had outstanding TPS, with a value of $1.2 billion.

The growth in TPS coincided with a period of economic expansion and record earnings for the banking industry from 2000 through 2006. During this time, BHCs used the proceeds from TPS to fund mergers and acquisitions, make capital contributions to subsidiary banks to support growth, repurchase common stock, and reduce the overall cost of capital.

TPS have proven to be an effective way to bolster a BHC's capital position when financial performance is strong. If a BHC or its subsidiary bank's financial condition (particularly, its capital levels) deteriorates, however, the limitations on including TPS for regulatory capital purposes and the restrictive covenants in the debentures could further exacerbate the institution's financial problems and raise supervisory concerns.

The market for TPS has essentially dried up during 2008 due to disruptions in the credit markets. As concerns escalate regarding the financial condition of the banking system in general and, specifically, the capability of the issuing entities to service payments, the ability of financial institutions to access capital markets through this vehicle has been severely constrained. Currently, only larger organizations find market acceptance of their issues—and, only then, at a prohibitive cost. The market for pooled TPS or trust preferred collateralized debt obligations (CDOs) is also unreceptive, thus eliminating an option for raising capital for most community banks. According to SNL, only 48 issuances of TPS totaling $19.2 billion were completed in 2008 compared to 210 deals valued at $40.5 billion in 2007.3

Adverse economic and market conditions have resulted in rating downgrades of TPS and significant valuation declines for these securities. For instance, on February 10, 2009, Standard and Poor's Ratings Services lowered its ratings on 35 tranches from 14 U.S. trust preferred CDOs. These downgrades reflect fears that institutions issuing TPS may be more likely to defer interest payments as the current economic crisis continues.4

Impact on Capital

TPS are considered restricted core elements of capital and may be included in tier 1 or tier 2 capital subject to certain limitations. Due to a rule change, the calculation for the restricted core elements considers goodwill as of the first quarter of 2009. More importantly, as the equity capital position deteriorates, the amount of TPS that qualifies for inclusion in regulatory capital declines, accelerating the ratio's downward trend. This is particularly troublesome for organizations that have made acquisitions and have a significant amount of goodwill.

Tier 1 capital. Effective March 31, 2009, the aggregate amount of restricted core capital elements that may be included in the tier 1 capital of a banking organization must not exceed 25 percent of the sum of all core capital elements, including restricted core capital elements, net of goodwill, less any associated deferred tax liability. In other words, the aggregate amount of restricted core capital elements is limited to one-third (33%) of the sum of core capital elements, excluding restricted core capital elements, net of goodwill, less any associated deferred tax liability.

Tier 2 capital. TPS-restricted core capital elements, including TPS in excess of the limit for tier 1, generally may be included in tier 2 capital. Beginning March 31, 2009, the aggregate amount of restricted core capital elements, term subordinated debt, and limited life preferred stock that may be included in tier 2 capital is limited to 50% of tier 1 capital.

Supervisory Issues

For regulators and bank supervisors, the most serious concern is that, as the capital position deteriorates, the amount of TPS that can be considered capital also decreases. Many institutions strengthen their capital position and fund their expansion through the issuance of TPS, so they face serious consequences if that balance sheet suddenly unwinds. Regulatory action may restrict dividends from the bank to the parent in order to protect the depository, thus creating liquidity consequences at the parent, which needs to service the TPS.

Understanding relevant documents. The issuance of TPS involves numerous legal documents and contracts, including the prospectus, the indentures, and the declaration of trust. It is imperative that management and counsel understand the terms of each document, as the definitions and specifics can vary. Failure to fully understand and comply with all of the provisions can present significant risk and result in costly consequences to the organization.

Generally, TPS have been issued during times of favorable economic and banking conditions. Therefore, the documents may have only been reviewed in light of the institution's condition at the time, without considering the repercussions of future issues.

Rank of junior subordinated debentures. The debentures issued in conjunction with the TPS rank pari passu, or equally, with all other junior subordinated debentures issued or to be issued by the BHC and are unsecured and rank subordinate and junior in right of payment to all senior indebtedness.

The pari passu provision requires a BHC to make the interest payments on these subordinated notes if the BHC makes an interest payment on any other debt that ranks the same or that is junior in interest to these debentures. In other words, the BHC cannot pick an order of payment that subordinates senior debt to junior debt.

Notification requirements. Deferral Notice—One of the key elements that qualifies TPS as tier 1 capital is the right to defer payments of interest on the debentures by extending the interest payment period at any time and from time to time during the term of the debentures, for up to five consecutive years. However, if the request to defer these payments is not provided to the trustee within the designated time frame, the BHC will be legally obligated to pay the interest on the debentures.

The notification requirements may vary among the issues when there are multiple debentures. Therefore, management or legal counsel must coordinate the notices so that they comply with the requirements of each individual debenture. Due to the pari passu provisions, failure to provide notice on any one of the debentures within the set time frame will legally require the BHC to make the interest payments on all of the debentures.

Events of Default—Within a designated period of time, the BHC shall inform the trustee of any event of default, as defined in the indenture.

Restrictions during the deferral period. Typically, during the deferral or extension period, the BHC is not permitted to declare or pay any dividends or distributions on—or redeem, purchase, acquire, or make a liquidation payment with respect to—any of its capital stock. In addition, it is not permitted to make any payment of principal, interest, or premium, if any, or repay, repurchase, or redeem any debt securities that rank pari passu with or junior in right of payment to the debentures. Nor is it permitted to make any guarantee payments if such guarantee ranks pari passu with or junior in right of payment to the debentures.

It is critical that a BHC's management that is considering acquiring a bank which has deferred interest payments understand the implications of this provision since the successor will also be held to the provisions of the indenture.

Source of strength enforcement actions. If it is necessary to put a BHC under an enforcement action to ensure that it can and will act as a source of financial and managerial strength for its bank subsidiaries, it may be appropriate to include a provision specifically addressing TPS, since dividends from the subsidiary bank often fund the interest payments. A troubled bank may not be in a position to pay dividends to its parent. A commonly used provision to enforce the source of strength doctrine is that the BHC cannot make any interest payments on the subordinated debentures related to the TPS without the prior written approval of the Reserve Bank, thereby preserving cash at the holding company level. The provision usually requires the BHC to submit pro forma financial information depicting the dividend's effect on the organization and the subsidiary bank for consideration in the Reserve Bank's decision process.

4(m) capital. BHCs that meet the criteria can elect to become financial holding companies (FHCs) and use the expanded banking powers given them under the Gramm-Leach-Bliley Act. When an FHC is placed under a 4(m) Agreement due to the capital position of its subsidiary bank, it must submit an acceptable capital restoration plan to the Federal Reserve. This plan must detail the specific actions that the parent company will take to restore the subsidiary bank to a "well-capitalized" condition. If the FHC has TPS, the plan should address the option to defer interest payments, explain the conditions under which this would occur, and provide pro forma financial statements that show the impact of deferring or not deferring the interest payments, as appropriate.

Other-Than-Temporary Impairment (OTTI)

Given the interrelated ownership of a financial institution's TPS by another banking organization, the underlying stability and strength of the issuing bank must be considered when assessing the risk associated with holding a security which is currently in the deferral phase of dividend payment. Given the extensive issuance of TPS over the past 10 years and the present danger for bank failures, the potential exists for many of these securities to default permanently.

In its report entitled "Continued Credit Concerns Face U.S. Bank TruPS CDOs," dated September 9, 2008, Fitch observed $1.7 billion in TPS defaults, deferrals, and credit risk sales across 38 banks since September 2007.3 This amount represents 5.1 percent of the outstanding TPS issued by banks. In comparison, in the seven years prior to September 2007, only $258.5 million in TPS defaults, deferrals, and credit risk sales across 11 banks was observed. Many issues remain, including creating uniform criteria for OTTI and for the recognition and valuation of securities that meet the evolving standards.

Future Accounting Landscape

Besides TPS offerings, the SPE is the vehicle of choice to remove assets from the parent's balance sheet and, under different names such as SIVs and QSPEs, is used for the entire range of securitizations, including mortgages and credit cards. The Financial Accounting Standards Board (FASB) recently proposed changes to FAS 140 and FIN 46(R), which significantly affect the "originate to distribute" model and would require all SPEs to be subject to consolidation review.

The proposed qualitative assessment in FIN 46(R) would make consolidation more likely, since the party with the power to make decisions for the SPE and the ability to benefit from the SPE is the primary beneficiary and must consolidate SPE. In other words, the SPE would no longer be a stand-alone, off-balance sheet (true sale) entity, but would be consolidated onto the parent's books for accounting purposes.

Conclusion

Significant issues surrounding the issuance of trust preferred securities have evolved that were not present as little as two years ago. It is clearly a market in transition, and, as such, the associated risks must be managed prudently.

  • 1   Data for 2007 obtained from the Consolidated Financial Statements for Bank Holding Companies (FR Y-9C) and Parent Company Only Financial Statements for Large Bank Holding Companies (FR-Y9LP).
  • 2   Eveson, Todd H., and Schram, John F., "Bank Holding Company Trust Preferred Securities: Recent Developments External Link," North Carolina Banking Institute, Vol. 11, 2007.
  • 3   Stoval, Nathan, "SNL 2008 League Tables: Most Capital Raising Done Inside the Beltway," SNLi, January 16, 2009.
  • 4   Hussain Atif, "S&P Lowers 35 Tranches from 14 US Trust Preferred CDO Transactions," SNLi, February 11, 2009.
  • 5   Fitch Ratings External Link

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.