David R. Evanson
Hybrid Products Instruments, Applications & Models, Spring, 2005
When the Federal Reserve Bank ruled in 1996 that proceeds from the issuance of trust preferred securities (TruPS) could account for up to 25% of tier one capital, it had a materially positive and significant impact on investors and issuers alike.
According to the Federal Reserve Board, tier one capital consists of core elements of stockholder’s equity including par value, additional paid in capital, qualifying cumulative and non cumulative perpetual preferred stock, as well as minority interests in the equity accounts of consolidated subsidiaries.
Trust preferred securities are subordinate to all debt on a company’s balance sheet, but senior to preferred and common stock. Most TruPS have 30 year, non-amortizing terms and pay quarterly or semi annual interest. Circumstances permitting, many trust preferred issues may defer interest for up to five years and have a call feature, which often starts at five years for smaller institutions and 10 years for larger ones.
The benefits of including trust preferred securities in tier one capital for depository institutions are manifold. First, it enables banks to access capital to fuel growth – organic or from acquisitions – that is non dilutive. Second, capital in the firm of trust preferred securities is inexpensive. Trust preferred securities are typically priced at LIBOR plus 1.50% to LIBOR plus 3.00%, depending on collateral, a coupon which is dramatically less expensive than the required return on equity for banking institutions which currently ranges from 12.00% to 15.00%, depending on the size of the institution. Third, trust preferred securities offer banks a tax efficient form of capital since interest payments are fully deductible, while preferred dividends are not.
For several years after the Federal Reserve granted tier one relief on trust preferred securities, they remained largely the province of larger banks. These institutions could gain economies of scale, lower their overall issuance costs, and offer enough securities to develop an adequate secondary market that would offer investors liquidity in addition to yield. While in theory the benefits of trust preferred securities were available to all depository institutions, in practice the required size of trust preferred issuances kept them out of reach of smaller institutions.
In 2000, four years after the Federal Reserve granted tier one capital relief, an innovative structure was developed which enabled smaller community and regional banks to capitalize on the demand for trust preferred securities among investors. Specifically, this breakthrough was the issuance of trust preferred securities from several institutions which were then pooled into a collateralized debt obligation, or CDO.
Thus the TruPS CDO market was born. Since 2000, more than $20 billion of new issues have come to the market making TruPS CDOs one of the largest new issue segments in the CDO sub sector in the United States. The rapid rise of the TruPS CDO is equally attributable to demand as well as supply influences.
The features affecting demand will be covered later in this chapter, along with regulatory influences, which play a role as well. Once available to small community banks, TruPS were readily embraced due to modest issuance costs, absence of dilution and tax efficiency.
To remove the abstraction of these benefits, consider the following real examples of regional banks in the United States using TruPS to drive growth in a way that was unthinkable just five years ago.
Product Expansion. First Community Bancorp ( NASDAQ: FCBP) in Rancho Santa Fe, CA is a bank holding company with approximately $2.7 billion in assets across two wholly owned subsidiaries, Pacific Western National and First National Bank. Through its’ 32 full-service community banking branches, First Community provides commercial banking services, including real estate, construction and commercial loans, to small and medium-sized businesses.
As 2003 came to a close, the bank’s senior management wanted to expand First Community’s commercial lending business, and felt a commercial finance company would round out the bank’s product offering. In February of 2004 First Community announced an all cash, $40 million deal to acquire First Community Financial Corp. (FC Financial) a commercial finance company headquartered in Phoenix, Arizona with whom it had a longstanding business relationship.
The acquisition would extend FCBP’s core lending products with higher margin products, and diversify its existing portfolio by increasing the commercial and industrial lending base. Additionally, because of FC Financialzzs historical success managing credit quality, the acquisition will provide additional risk management expertise for FCBP’s current portfolio.
Operationally the fit was good. But a $60 million issuance of trust preferred securities, which was part of a larger TruPS CDO, to finance the FC acquisition, as well as the acquisition of Harbor National Bank, helped make the transaction more financially viable, and less expensive for First Community’s existing shareholders.
At the time the transaction was announced, First Community common stock was trading at $38.35. With 15.4 million shares outstanding, First Community had a $585 million market capitalization. To finance the acquisition with stock, First Community would have had to issue 1.04 million shares. However, the use of trust preferred securities to finance the transaction avoided dilution of 6.8% of existing shareholder’s interests.
Geographical Expansion. Atlanta- Based Main Street Banks, with $1.8 billion in assets at the commencement of 2003 and 27 branches operating in metropolitan Georgia, offering banking, brokerage, insurance and mortgage products, wanted to expand geographically. Main Street felt First Colony Bancshares offered an attractive opportunity. First Colony with $320 million in assets, had an impressive franchise in the northern part of the state, which would enable Main Street, to diversify its corporate and retail customer base as well as diversify risk in its loan portfolio.
The $96 million acquisition of First Colony by Main Street in the second quarter of 2003 was financed with 2.6 million Main Street shares, then trading at $21.28, and $45 million in cash which came in the form of proceeds from a trust preferred issuance pooled in a collateralized debt obligation. At the time of the transaction, Main Street had 16.8 million shares outstanding. The $45 million cash portion of the transaction, financed with TruPS priced at LIBOR plus 325 basis points, avoided the issuance of 2.1 million shares of common. Thus, trust preferred securities enabled the holders of the bank’s 16.8 million shares outstanding to avoid dilution of 12.5%.
Main Street emerged from the transaction, not only re energized strategically, but a much better capitalized bank. Prior to the transact addition, Main Street had tier one capital of $139 million consisting solely of shareholder equity accounts consisting common stock, no par value and retained earnings. Post transaction, Main Street had tier one capital $239 million consisting of shareholder’s equity of $189 million and $50 million of trust preferred securities.
Enhancing Shareholder Returns. Oregon Pacific Bancorp, a tiny bank holding company operating in Oregon’s coastal and island communities with just $138 million in assets and trading on the OTC Bulletin Board was impressive in every respect but its size. Its net interest margin of 5.35% bests most regional as well as money center banks. Despite strong fundamentals, growing loan volume, and a virtually unchallenged franchise in its market, Oregon Pacific was not institutional grade. However inside of a pooled issuance of trust preferred securities, Oregon Pacific was able to raise $4.1 million, enhance its capital base, and make a positive contribution to the overall CDO.
In addition to facilitating derivative access by institutional investors to Oregon Pacific’s strong fundamentals, the proceeds from the trust preferred securities also allowed Oregon Pacific’s shareholders to enhance their return on equity by financing a common stock share buyback. In essence, the TruPS CDO structure created a bridge which permitted fixed income institutional investors as well as individual equity investors to recognize the inherent value of Oregon Pacific by filtering out the inefficiencies of its size and trading venue.
In all three instances, TruPS enabled the institution which issued them to grow their risk based assets, or to enhance capital ratios, or both. The hypothetical example below provides a closer look at what happens when trust preferred securities are issued from the perspective of three ratios which regulators focus on: total risk based capital ratio, the tier 1 risk-based capital ratio and the tier
1 leverage ratio.
• The total risk-based capital ratio is total risk capital (tier 1 plus tier 2) divided by total risk-based assets.
• The tier 1 risk-based capital ratio is tier 1 capital divided by total risk-based assets
• The tier 1 leverage ratio is average total assets for leverage (average assets less intangible assets) divided by tier one capital.
Generally speaking, U.S. bank regulators designate a bank well-capitalized if the total risk-based capital ratio is at least 10%, the tier one capital ratio is at least 6% and tier 1 leverage ratio is at least 5%. The hypothetical institution below with $280 million in assets, $15 million in tier 1 capital and $10 million in tier 2 capital has excess risk based capital, tier 1 risk based and tier 1 leverage ratios respectively of 10.64%, 6.68% and 5.66% respectively.
Hypothetical Banking Corp.
Current Capital Statistics
Institution Type BHC
Total Assets $280,000
Total equity $15,000
Tier 1 capital $15,000
Tier 2 capital $10,000
Total risk-based capital $25,000
Total risk-weighted assets $235,000
Average total assets for leverage $265,000
Trust Preferred Issued $0
Max Total Trust Preferred – Tier 1 $5,000
Equity Capital to Total Assets 5.36
Total risk-based capital ratio 10.64
Tier 1 risk-based capital ratio 6.38
Tier 1 leverage ratio 5.66
Excess Capital & Maximum Increase in Assets
Total risk-based capital ratio 10.00%
Total risk-based capital ratio – excess $1,500
20% risk-weighted – asset growth $75,000
50% risk-weighted – asset growth $30,000
100% risk-weighted- asset growth $15,000
Tier 1 risk based capital ratio 6.00%
Tier 1 risk based capital ratio – excess $900
20% risk-weighted – asset growth $75,000
50% risk-weighted – asset growth $30,000
100% risk-weighted- asset growth $15,000
Tier 1 leverage ratio 5.00%
Tier 1 leverage ratio – excess $1,750
asset growth $35,000
Source: Cohen Brothers & Company, Philadelphia, PA
Without any new capital, the institution can grow its corporate loan portfolio (100% weighted) by just $15 million, and its mortgage portfolio (50% risk weighted) by just $30 million. Assets that are not risk weighted, such as government securities, or assets that are risk weighted by just 20%, consisting of primarily of inter company transfers and loans, do not represent the kind of growth that offers the likelihood of a premium for the company’s publicly traded common equity.
If the institution’s market place demands loans that are 100% risk weighted, then the most it can expect to grow in the coming year without any new capital is just 5.36% ($15 million/$280 million), a rate not likely to earn its publicly traded shares a premium.
How does the introduction of $5 million in trust preferred securities change the scenario?
Hypothetical Banking Corp. with
Application of $5 million of TruPS
Additional:
Trust Preferred Securities $5,000
BHC
Total Assets $285,000
Total equity $15,000
Tier 1 capital $20,000
Tier 2 capital $10,000
Total risk-based capital $30,000
Total risk-weighted assets $235,000
Average total assets for leverage $265,000
Equity Capital to Total Assets 5.26
Total risk-based capital ratio 12.77
Tier 1 risk-based capital ratio 8.51
Tier 1 leverage ratio 7.55
Excess Capital & Maximum Increase in Assets )
Total risk-based capital ratio 12.77%
Total risk-based capital ratio – excess $6,500
20% risk-weighted – asset growth $325,000
50% risk-weighted – asset growth $130,000
100% risk-weighted- asset growth $65,000
Tier 1 risk based capital ratio 8.51%
Tier 1 risk based capital ratio – excess $5,900
20% risk-weighted – asset growth $491,667
50% risk-weighted – asset growth $196,667
100% risk-weighted- asset growth $98,333
Tier 1 leverage ratio 7.55%
Tier 1 leverage ratio – excess $6,750
asset growth $135,000
Source: Cohen Brothers & Company, Philadelphia, PA
With the application of $5 million in TruPS, the same hypothetical institution can grow its’ 100% risk based assets by $65 million, and achieve annual growth in assets of 22.81%, a rate at which it’s common equity can perhaps command a premium.
Casting aside for a moment the demands of the market place, and focusing on total asset growth through the tier 1 leverage ratio, the application of $5 million of trust preferred securities offers total maximum asset growth of $135 million, or 47.37% versus 12.50% without the application of TruPS. Clearly TruPS offers management teams predisposed toward growth a flexible and inexpensive tool with which to do it.
As mentioned, the rapid rise of TruPS CDOs is attributable not just to the supply of collateral, but also the demand from investors. Among institutional investors seeking yield, TruPS offer a premium over other similarly-risked securities.
Primary CDO spreads to 3-Month Libor
Leveraged Structured Hybrid Commercial
Loans Finance TruPS* Real Estate
AAA 32 39 52 33
AA 58 90 115 49
A 105 150 160 90
BBB 200 310 NA 155
BB 560 NA NA NA
Source: Merrill Lynch
* Hybrid TruPS are 75% bank and 25% insurance collateral
But in addition to a yield premium, once TruPS were pooled from several depositories into a single CDO, an entire new segment of the banking market – regional and community banks – were opened up to institutional investors.
This was a significant and positive development. To understand why, consider the performance of small banks, those with assets of less than $1 billion, versus larger banks, those with assets greater than $1 billion over time.
For instance, the marked difference in core funding has a direct impact on the net interest margin of large banks versus small banks. Because a larger percentage of smaller banks’ funding consists of relatively inexpensive deposits they are, on average, able to earn higher net interest margin spreads.
Source: FDIC
Not surprisingly, smaller banks are more liquid than their larger competitors when these core deposits are measured as a percentage of total assets.
Source: FDIC
In addition to higher liquidity, smaller depository institutions offer greater safety because they tend to have higher loan quality.
Source: FDIC
In addition, smaller banks offer a higher degree of safety because they generally maintain higher capital adequacy ratios.
Source: FDIC
Yet for this diminished risk, smaller banks offer investors comparable or, at times, superior return on assets.
Source: FDIC
So it’s little surprise that smaller banking institutions were a source of frustration for investors: attractive collateral features but no realistic access through the debt markets, and diminished, or even exasperating access through the equity markets since many institutions trade less than 10,000 shares a day. This liquidity issue is aptly illustrated by the chart below which shows comparative liquidity of large banking institutions versus smaller ones.
Source: SNL Financial, Cohen Brothers & Company
As mentioned however, the pooled CDO approach overcame the structural impediments of the issuers and their trading patterns. For the first time, large institutional investors could realistically diversify their risk profile within the banking segment. Because of this, new issues of TruPS CDOs are enthusiastically received by institutional investors, and suggests likely increases in overall volume during the next five years.
Interestingly, just as TruPS CDOs were gaining momentum, their tier 1 capital treatment was called into question by a Financial Account Standards Board interpretation of Variable Interest Entities in late 2003. However, the apparent resolution of this issue may have ultimately strengthened the foothold TruPS CDOs have gained in the banking industry.
The Financial Accounting Standards Board called tier 1 capital treatment into question with a revision to FASB Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46) with FIN 46R. The revision by the FASB came in response to Enron and the role that Special Purpose Entities played in the catastrophe.
However shortly after this interpretation, The Federal Reserve proposed amendments to its risk based capital rules which included, among other items, continued tier 1 capital treatment for trust preferred securities. In support of these amendments, The Federal Reserve made several clarifying remarks which appear to a have secured the tier one status of trust preferred securities.
In citing its reasons for the continued inclusion of TruPS in tier one capital, the Federal reserve cited a supervisory experience that was characterized as “Positive.” In the proposed amendments, the Federal Reserve noted, “trust preferred securities have proven to be a useful source of capital funding for BHCs, which often downstream the proceeds in the form of common stock to subsidiary banks, thereby strengthening the banks’ capital bases.”
The Federal Reserve went further in its support of trust preferred securities, not just as stand alone instruments, but also as pooled securities inside of a CDO. “From a competitive equity point of view, poolings of trust preferred securities have permitted small BHCs for the first time to access the capital markets for tier 1 capital, which larger BHCs have long enjoyed. No alternative tier 1 structure to trust preferred securities has emerged . . .” The Federal Reserve noted that with respect to large BHCs, preventing them access to a tax efficient capital instrument might place them at a competitive disadvantage to foreign banks which have $125 billion of similar, tax efficient capital on their books already.
Most importantly in its proposed amendments, the Federal Reserve addressed how the recent interpretations by the FASB, FIN 46 and FIN 46R, could lead to new GAAP treatment of trust preferred securities issued out of a special purpose entity on the balance sheet of a bank holding company. And while the Federal Reserve reiterated its longstanding direction that bank holding companies are required to follow GAAP for regulatory reporting purposes as well as accounting purposes, it went to some lengths to parse the logic of inter related regulatory bodies to assert its dominion over the affairs of banking institutions – particularly with respect to the regulatory definition of capital.
Specifically: “The change in the GAAP accounting treatment of a capital instrument does not necessarily change the regulatory capital treatment of that instrument. Although GAAP informs the definition of regulatory capital, the Federal Reserve is not bound by GAAP accounting in its definition of tier 1 or tier 2 capital because these are regulatory constructs designed to ensure the safety and soundness of banking organizations, not accounting designations designed to ensure the transparency of financial statements. The current definition of tier 1 capital differs from GAAP equity in a number of ways that the Federal Reserve has determined are consistent with its’ responsibility for ensuring the soundness of the capital bases of banking organizations under its supervision.”
With this regulatory orientation firmly established by the Federal Reserve, it would appear the growth and longevity of the TrusPS CDO market is a three-legged stool.
Issuer benefits of cost, tax efficiency and anti-dilution are met in equal measure by investor benefits of yield premium and access to the entire continuum of the banking industry and the opportunity to diversify their risk profile. However, supply and demand appear to be substantially buttressed by a favorable regulatory outlook for TruPS.
