Trust Preferred Securities and the Capital Strength of Banking Organizations

Home , Subordinated debt, Tangible common equity

uring the year 2010, legisla- which a BHC creates a wholly owned tors and regulators undertook special purpose entity (SPE). The SPE Da number of significant regula- issues cumulative preferred stock to tory reforms in response to the finan- investors. The BHC then borrows the cial crisis. One important theme of proceeds from the SPE using a long- these reforms is the need for banking term subordinated note. Under then organizations to have stronger capi- current accounting rules, the BHC tal positions to weather periods of consolidated the SPE, and the financ- economic stress. This paper discusses ing transaction gave rise to a minority one component of regulatory capital interest in the consolidated subsid- that was the subject of significant iary. The press release announced discussion, debate, and ultimately, that under certain conditions, this reform during 2010: trust preferred minority interest in the SPE would securities (TruPS) issued by Bank meet a portion of the tier 1 capital Holding Companies (BHCs). requirements for BHCs. TruPS are hybrid securities that Generally Accepted Accounting are included in regulatory tier 1 Principles (GAAP) in use at the time capital for BHCs and whose dividend of the 1996 announcement masked payments are tax deductible for the the underlying economics of the issuer. Since the Federal Reserve transaction: the BHC was in effect Board’s (Federal Reserve) 1996 deci- issuing term subordinated debt into sion to allow TruPS to meet a portion the marketplace and it was this subor- of BHCs’ tier 1 capital requirements, dinated debt that really was being many banking organizations have permitted in tier 1 capital. Since found these instruments attractive the SPE’s sole asset is the subordi- because of their tax-deductible status nated note from its parent BHC, any and because the increased leverage dividend payments the SPE pays to provided from their issuance can the trust preferred investors are, in boost return on equity (ROE). substance, simply the BHC’s interest payments on the subordinated debt. The increased leverage implied Moreover, while the TruPS themselves by the use of TruPS is a two-edged have no maturity date, their effective sword. Evidence suggests that bank- life is limited as the trust typically ing organizations that issued these terminates at the maturity date of instruments were weaker as a result, the subordinated debt, by which time took more risks, and failed more the BHC bears a legal obligation to often than those that did not. The repay this debt in accordance with its unsatisfactory experience with these contractual terms. instruments was one factor that set the stage for reforms that will require The Internal Revenue Service (IRS) banking organizations to hold higher recognized the economic substance of quality capital in the future. the trust preferred structure as a debt issuance of the BHC. As described by the Federal Reserve in a 2005 rule- An Introduction to TruPS making, “A key advantage of TruPS The significant use of TruPS on BHC to BHCs is that for tax purposes the balance sheets dates to an October dividends paid on TruPS, unlike those 21, 1996 press release issued by the paid on directly issued preferred Federal Reserve. The press release stock, are a tax-deductible interest described a financing structure in expense. The Internal Revenue Service

3 Supervisory Insights Winter 2010 Trust Preferred Securities continued from pg. 3

ignores the trust and focuses on the of insured banks are subsidiaries of interest payments on the underlying a bank holding company. Although subordinated note.”1 banks are separately regulated from their parent holding companies, many TruPS became extremely popular are linked to their parent through among banking organizations because capital transfers, including dividends their dividends are tax deductible and from the bank to the holding company their issuance does not dilute equity of and capital infusions from the parent the BHC. Of the roughly 1,025 BHCs company down-streamed to the bank. reporting on form Y-9C as of June 30, 2010, nearly two-thirds (664) reported Smaller bank holding companies typi- some amount of TruPS in their tier 1 cally did not bring TruPS directly to capital during the past five years, with market. Instead, these organizations close to half of those (308) reporting often would sell their TruPS into a TruPS exceeding 25 percent of tier 1 collateralized debt obligation (CDO). capital at one point during that time. These CDOs, which commingled Roughly half the 308 banking compa- TruPS issued by smaller banking nies with higher dependence on TruPS organizations and other entities, were were smaller banking companies with tranched and sold to investors. Fitch total assets of $1 billion or less. reported that since the year 2000, 1,813 banking entities issued TruPS The Federal Reserve’s decision to that were purchased by TruPS CDOs, allow TruPS to satisfy part of BHCs’ in an aggregate amount of roughly $38 tier 1 capital requirement was impor- billion.2 The federal banking agen- tant to insured banks as well. As indi- cies deemed these CDOs permissible cated in Table 1, more than 70 percent investments for insured institutions,3

Table 1 Distribution of Insured Depository Institutions by Parent Subsidiaries Subsidiaries No Bank All Insured Asset Range of Insured of Other of Top Tier Holding Depository Depository Institutions Holding Y-9C-filers Company Institutions Companies Over $100 billion 19 0 0 19 $15-$100 billion 38 5 10 53 $1 to $15 billion 431 20 137 588 $500 million to $1 billion 492 47 162 701 Under $500 million 536 4,105 1,828 6,469 All Depository Institutions 1,516 4,177 2,137 7,830 Data as of June 30, 2010; Source Bank and Thrift Reports, Y-9C Reports. Subsidiaries of other holding companies may include subsidiaries of foreign parents or non-financial holding companies. Subsidiaries of thrift holding companies would be listed under “No Bank Holding Company.”

1 See Risk-Based Capital Standards: Trust Preferred Securities and the Definition of Capital , 70 Fed. Reg. 11827 (March 10, 2005). http://www.federalregister.gov/articles/2005/03/10/05-4690/riskbased-capital-standards-trust- preferred-securities-and-the-definition-of-capital. 2 “Fitch Bank TruPS CDO Default and Deferral Index,” November 2010, Structured Credit Special Report, FitchRat- ings. http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=576606. 3 See, for example, Interpretive Letter No. 777, Office of the Comptroller of the Currency, April 8, 1997; and “Invest- ments in Trust Preferred Securities,” FDIC Financial Institution Letter FIL-16-99, February 19, 1999.

4 Supervisory Insights Winter 2010 meaning that banking organizations of adversity. Because of the cumula- could both issue these securities as tive dividend obligation, however, the capital and purchase them as debt. deferral of dividends does not protect the accounting solvency of the organi- TruPS are rated as debt instruments zation. Specifically, during the defer- by the rating agencies. Correspond- ral period, the BHC must record a ingly, for issuers, the rating agen- liability and interest expense for the cies substantially discounted the amount of the accrued but deferred contribution of TruPS to the capital interest payable on the subordinated strength of banking organizations. debt at the end of each period in For example, according to Moody’s, which dividends are deferred, and “[w]e have always considered TruPS this liability and the related inter- to be far more debt-like in nature, and est expense continue to accrue at have generally not assigned them any the interest rate on the subordinated ‘equity credit’ in evaluating the capital debt until all deferred interest and structure of highly rated issuers.”4 the corresponding amount of deferred The Federal Reserve imposed a dividends are paid. number of conditions that, in its The events that transpire in the event view, warranted allowing TruPS to of deferral and ultimate non-payment meet a portion of BHCs’ tier 1 capital of dividends are important to under- requirements despite their economic standing the limits to the loss absorp- substance as debt. Conditions for tion capacity of TruPS. As described by tier 1 status included the ability to the Federal Reserve, “The terms of the defer dividends for at least five years; TruPS allow dividends to be deferred subordination of the BHC’s long-term for at least a twenty-consecutive quar- subordinated note to the SPE to other ter period without creating an event BHC debt including all other subordi- of default or acceleration. After the nated debt; maturity of this intercom- deferral of dividends for this twenty pany subordinated note at the longest quarter period, if the BHC fails to feasible maturity; a prohibition on pay the cumulative dividend amount redemption without prior approval of owed to investors, an event of default the Federal Reserve; and a require- and acceleration occurs, giving [trust ment for the TruPS along with other preferred] investors the right to take cumulative preferred stock to comprise hold of the subordinated note issued no more than 25 percent of the BHC’s by the BHC [to the SPE]. At the same core capital elements. time, the BHC’s obligation to pay prin- One of the most important features of cipal and interest on the underlying TruPS the Federal Reserve relied upon junior subordinated note accelerates in granting tier 1 capital status was the and the note becomes immediately due ability to defer dividends. This feature and payable.”5 allows the BHC some flexibility to stop At the end of the deferral period, the interest payments on the subor- then, the TruPS investors would be dinated debt and redirect cash flows left holding a deeply subordinated within the company during a period

4 “Impact on Federal Reserve’s Proposed Rule for Trust Preferred Securities on Moody’s Ratings for U.S. Banks,” Moody’s Investors Service, May 2004. http://v3.moodys.com/researchdocumentcontentpage. aspx?docid=PBC_87135. (Reader must register on this site to access documents.) 5 See Risk-Based Capital Standards: Trust Preferred Securities and the Definition of Capital, 70 Fed. Reg. 11827 (March 10, 2005). http://www.federalregister.gov/articles/2005/03/10/05-4690/riskbased-capital-standards-trust- preferred-securities-and-the-definition-of-capital.

5 Supervisory Insights Winter 2010 Trust Preferred Securities continued from pg. 5

note of the BHC, which would be interest in consolidated subsidiaries. likely to absorb substantial loss in the In addition, certain assets deemed to event of the BHC’s failure. As noted, be insufficiently reliable or permanent however, all cumulative dividend are deducted for purposes of calculat- arrearages must be paid in full if the ing a bank’s tier 1 capital.6 BHC is to continue to operate as a Voting common equity is the owner- going concern. ship stake of those ultimately in control of the bank’s risk-taking, has TruPS and Regulatory Capital no contractual interest or dividend for Insured Banks payments or redemption rights, and therefore is fully available to absorb The most important function of losses while the bank continues bank capital is to absorb unexpected to operate. Regulators view voting losses while the bank continues to common equity, net of deductions, operate as a going concern. This as the highest form of bank capital. shock-absorber function increases the Recently, this view was reinforced by likelihood that a bank can withstand an agreement announced by the Group a period of economic adversity, while of Central Bank Governors and Heads system-wide, adequate capital ensures of Supervision on September 12, 2010.7 the banking industry as a whole can continue to lend during a downturn. The regulatory capital treatment A secondary function of bank capital of preferred stock issued by insured is to absorb losses after the bank has banks illustrates the conceptual failed, thereby reducing the cost of the view of tier 1 capital just described. failure to the deposit insurance fund. Preferred stock is senior to equity in Capital also plays an important role in liquidation but junior to other credi- mitigating moral hazard by ensuring tors. It may carry a stated dividend that the owners, who reap the rewards and, like a bond, may be rated by when a bank’s risk-taking is success- the major credit ratings agencies. To ful, have a meaningful stake at risk. receive tier 1 capital status, however, an insured bank’s preferred stock Bank regulators distinguish between must not have a maturity date or any “core capital elements” (tier 1) and feature that will, legally or as a prac- “supplementary capital elements” tical matter, require future redemp- (tier 2). Generally speaking, core capi- tion. Moreover, to qualify for tier 1 tal elements are those that are fully capital status for insured banks, the available to absorb losses while the preferred stock cannot have a cumu- banking organization operates as a lative dividend obligation. Given going concern. Regulators expect core these restrictions, noncumulative or tier 1 capital to consist predomi- perpetual preferred stock is viewed nantly of voting common equity. Other by the banking agencies as having permissible tier 1 capital elements sufficient ability to fully participate for insured banks are noncumula- in losses on a going-concern basis tive perpetual preferred stock and, to warrant its inclusion in insured in certain circumstances, minority banks’ tier 1 capital.

6 These deductions include goodwill and other intangible assets (except a limited amount of mortgage servicing assets, nonmortgage servicing assets, and purchased credit card relationships), certain credit-enhancing interest-only strips, certain deferred tax assets, identified losses, certain investments in financial subsidiaries and certain non-financial equity investments. These deductions, among others, are described in detail in the banking agencies’ capital regulations. 7 http://www.bis.org/press/p100912.htm.

6 Supervisory Insights Winter 2010 Historically, dating back to at least 1989, the definition of tier 1 capital Financial Reporting for TruPS at BHCs has been more permissive As noted in the first section, the than the corresponding definition for economic substance of the issu- insured banks. For example, since ance of TruPS was that the BHC was 1989 the Federal Reserve has permit- financing itself with subordinated ted qualifying cumulative perpetual debt. Financial reporting require- preferred securities to comprise up ments eventually came to recognize to 25 percent of a BHC’s tier 1 capi- this reality with the issuance by the tal.8 In contrast, cumulative preferred Financial Accounting Standards Board stock does not qualify as tier 1 capital (FASB) in January 2003 of FASB for insured banks. As another example Interpretation No. 46, Consolidation of differences in tier 1 capital defi- of Variable Interest Entities (FIN 46), nitions between BHCs and insured followed by a revision (FIN 46R) banks, mandatory convertible securi- in December of that year. These ties are subordinated debt securities changes recognized the substance of that convert to common stock or the TruPS structure by normally no perpetual preferred stock at a future longer requiring the consolidation of date. For an insured bank, these secu- the SPE created to issue the TruPS. rities are considered hybrid capital As a consequence, BHCs began to instruments that, subject to certain report the subordinated debt issued conditions, qualify as tier 2 capital. to the SPE as a liability instead of For BHCs, however, subject to prior reporting the preferred stock as a approval by the Federal Reserve in minority interest in a consolidated each instance, these securities may subsidiary. qualify as tier 1 capital. In its March 2005 rulemaking10 to The 1996 approval of TruPS as tier 1 address the effects of the accounting capital for BHCs was based in part on change, the Federal Reserve decided the fact that the cumulative preferred to retain the tier 1 capital status stock issued to investors by the SPE of TruPS for BHCs, although with appeared on the BHC’s balance sheet a lower limit for large, internation- as a minority interest in a consoli- ally active organizations. The rule dated subsidiary. Since the minor- specified that these large banks were ity interest consisted of cumulative required to reduce their reliance on preferred stock, however, this minor- restricted core capital elements11 to ity interest would not have qualified 15 percent of core capital elements for tier 1 capital status if the SPE had (including restricted core capital been a subsidiary of an insured bank.9

8 See 12 CFR part 225, App. A, II.A.1a(iv). http://www.fdic.gov/regulations/laws/rules/6000-1900. html#fdic6000appendixa. 9 See Interpretive Letter No. 894, Office of the Comptroller of the Currency, March 10, 2000. http://www.occ.gov/ static/interpretations-and-precedents/oct00/int894.pdf. 10 See 12 CFR part 225, App.A, II.A.1.b. http://www.fdic.gov/regulations/laws/rules/6000-1900. html#fdic6000appendixa. 11 12 CFR part 225, App.A, II.A.1.a. Restricted core capital elements are defined to include qualifying cumulative perpetual preferred stock (and related surplus), minority interest related to qualifying cumulative perpetual preferred stock directly issued by a consolidated U.S. depository institution or foreign bank subsidiary (Class B minority interest), minority interest related to qualifying common or qualifying perpetual preferred stock issued by a consolidated subsidiary that is neither a U.S. depository institution nor a foreign bank (Class C minority interest) and qualifying trust preferred securities. http://www.fdic.gov/regulations/laws/rules/6000-1900. html#fdic6000appendixa.

7 Supervisory Insights Winter 2010 Trust Preferred Securities continued from pg. 7

elements)12 net of goodwill less any smaller organizations could—and as associated deferred tax liability, described below, often did—comprise down from 25 percent of core capi- significantly more than 25 percent of tal elements before the deduction of actual tier 1 capital. goodwill, by March 31, 2009.13 TruPS are by far the most popular The Federal Reserve’s limit for of the unique tier 1 capital elements restricted core capital elements for available only to BHCs. As indicated smaller organizations remained at in Table 2, as of June 30, 2010, the 25 percent of the sum of core capital amount of qualifying TruPS outstand- elements (including restricted core ing in tier 1 capital at BHCs reporting capital elements), net of goodwill less on form Y-9C was $130 billion, repre- any associated deferred tax liabil- senting the majority of the roughly ity. To put this another way, TruPS $161 billion in total restricted capi- could comprise up to 25 percent of tal items.14 While most of the dollar a grossed up tier 1 capital number volume of these items was at the that did not reflect deductions for largest banks, smaller bank holding disallowed intangible assets, disal- companies as a group had the highest lowed deferred tax assets and other reliance on TruPS in tier 1. deductions. Thus, in effect, TruPS for

Table 2 Restricted Elements in BHC Tier 1 Capital Trust Mandatory Cumulative Share % of Trust Asset Range of Bank Preferred Covertible Preferred of Tier 1 Preferred in Holding Companies Securities Securities Stock Capital Tier 1 Over $100 billion $105.5 $20.1 $9.1 15.1% 11.8% $15 to $100 billion $8.4 $0.0 $0.1 7.1% 7.0% $1 to $15 billion $13.0 $0.0 $1.2 12.3% 11.3% $500 million to $1 billion $2.9 $0.0 $0.2 10.8% 10.1% Under $500 million $0.4 $0.0 $0.0 13.0% 13.0% All Reporting BHCs $130.1 $20.2 $10.5 13.9% 11.2% Data as of June 30, 2010; Source Y-9C Reports.

12 12 CFR part 225, App.A, II.A.1. Core capital is defined as common stockholders’ equity; qualifying noncumulative perpetual preferred stock (including related surplus); qualifying cumulative perpetual preferred stock (including related surplus); and minority interest in the equity accounts of consolidated subsidiaries. http://www.fdic.gov/ regulations/laws/rules/6000-1900.html#fdic6000appendixa. 13 12 CFR part 225, App. A, II.A.1.b. Compliance was later delayed until March 31, 2011; http://www.fdic.gov/regulations/laws/rules/6000-1900.html#fdic6000appendixa and http://federalregister.gov/a/E9-6096. 14 “Fitch Bank TruPS CDO Default and Deferral Index,” November 2010, Structured Credit Special Report, FitchRat- ings. http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=576606.

8 Supervisory Insights Winter 2010 hood of failure rather than rescue, TruPS in a Stressed Banking which increases the FDIC’s costs. Environment Finally, when TruPS are issued by The experience of the past several one BHC as capital and owned by years suggests that BHCs that relied another bank, the resulting double on TruPS as regulatory capital were counting of capital in the banking weaker because of that reliance, system creates inter-linkages that assumed more risk, and failed at a magnify the effects of losses. higher rate than other BHCs. There are four reasons for this. Leverage. As noted earlier in the paper, issuing TruPS became very First, reliance on TruPS increased popular among banking organiza- the financial leverage in banking tions. Chart 1 shows the percentage organizations, making them less of BHCs (those filing a form Y-9C) resilient in the face of adversity. that have used TruPS over time Second, heavy users of TruPS to meet part of their tier 1 capital appear to have levered the requirements. Among those BHCs proceeds to make riskier than that issued TruPS, the percentage normal loans, perhaps in response of TruPS in tier 1 capital increased to pressures to meet aggressive steadily during the years leading up return on equity targets. to 2007, when the average reached 18 percent. Third, when an organization has issued TruPS, the FDIC has more The TruPS dependence figures difficulty attracting investors to reported in Chart 1 are averages. the institution in a stressed situa- Many BHCs’ TruPS comprised more tion while the institution remains than 25 percent of their tier 1 capi- open. This increases the likeli- tal. For example, almost one-half of the 664 BHCs that filed a form Y-9C

Chart 1: Percent of Qualifying TruPS to Tier 1 Risk-Based Capital

% TruPS/Tier 1 % Reporting TruPS

80% 20% % Reporting TruPS/Tier 1 (L) TruPS (R) 18%

16% 60%

12% 40%

20% 4%

0% 0% 97 98 99 00 01 02 03 04 05 06 07 08 09 2Q10

Source: Y-9C Reports for those BHCs reporting TruPS.

9 Supervisory Insights Winter 2010 Trust Preferred Securities continued from pg. 9

as of June 30, 2010 and included Y-9C also issued TruPS. Specifically, TruPS as regulatory capital between 685 of the 4,025 small parent BHCs 2005 and 2009 reported that their reporting in June 2010 had subordi- TruPS represented over 25 percent of nated debt outstanding to SPEs that tier 1 capital at one time. issued TruPS. Among these 685 small BHCs, comprising 734 FDIC-insured A small minority of the many subsidiaries, reliance on TruPS was smaller BHCs that did not file a form very high. In aggregate, TruPS stood at about 35 percent of GAAP equity Chart 2: Bank Holding Companies with TruPS - Distribution of 2Q10 Adjusted Tier 1 RBC for these 685 organizations. Ratio, Less TruPS Including TruPS within tier 1 capital at these levels materially reduces a banking organization’s ability to 400 absorb losses. For example, a BHC reporting a tier 1 leverage ratio of 5 percent, of which 25 percent or 1.25 300 289 percentage points consists of TruPS, has loss absorbing capital of 3.75 percent of assets, a level of capital 200 165 that would result in an undercapitalized designation for an insured bank. 97 If losses equal to 1 percent of assets 100 are sustained, the organization will 45 38 report a tier 1 leverage ratio of 4 percent but have loss absorbing capi- 0 tal of 2.75 percent of assets, resulting Under 4% 4 to 6% 6 to 8% 8 to 10% Over 10% in a significantly undercapitalized designation if the entity were an Source: Y-9C Reports as of June 30, 2010. insured bank. Charts 2 and 3 convey a sense of how the use of TruPS by BHCs has Chart 3: Insured Banks of BHCs with TruPS - Distribution of 2Q10 Tier 1 RBC Ratio reduced the effective loss absorbing capital of these organizations rela- tive to the capital strength of their insured bank subsidiaries. The 634 779 800 BHCs that reported TruPS in their tier 1 capital at June 30, 2010, had 929 insured depository institution 600 subsidiaries. Only 6 percent of all these insured banks reported tier 1 risk-based capital ratios (not includ- 400 ing TruPS) of less than 8 percent of risk-weighted assets. Another 200 10 percent of these insured banks 94 reported tier 1 risk-based capital 14 16 26 ratios of between 8 percent and 10 0 percent of risk-weighted assets. Under 4% 4 to 6% 6 to 8% 8 to 10% Over 10% When the same entities are viewed as consolidated BHCs, their distri- Source: Bank Call Reports as of June 30, 2010. bution of capital ratios is markedly weaker. About 28 percent of these

10 Supervisory Insights Winter 2010 634 BHCs would have tier 1 risk- than other BHCs. Moreover, BHCs based capital ratios of less than 8 with the heaviest reliance on TruPS percent if their TruPS were excluded exhibited a higher risk profile than from tier 1 capital as it is excluded BHCs that used TruPS but had less for an insured bank. Another 26 reliance on them. percent of these BHCs would have Table 3 shows selected financial reported tier 1 risk-based capital ratios for the 1,025 bank holding ratios of between 8 percent and 10 companies filing form Y-9C as of June percent of risk-weighted assets if 30, 2010 over the five-year period their TruPS were excluded from tier 2005-2009. The 308 BHCs with a 1 capital. higher dependence on TruPS showed In short, the use of TruPS in tier 1 less favorable financial performance capital enabled these banking orga- compared to those that had a smaller nizations, as a group, to operate with amount of TruPS and those that substantially less loss absorbing capi- had no TruPS during that period. tal on a consolidated basis than did Delinquency ratios and net charge- their insured bank subsidiaries. offs were higher, and earnings were lower. Similar trends were noted Risk profile. BHCs that relied on at the insured banking subsidiar- TruPS to meet tier 1 capital require- ies of these holding companies, as is ments exhibited a higher risk profile expected since the assets of most of

Table 3 Financial Performance Time Series by Dependence on TruPS Bank Holding Companies with Higher Dependence on TruPS Financial Ratios (%) 2005 2006 2007 2008 2009 Average Delinquency Ratio 1.25 1.28 2.20 3.83 6.02 Average Net-Charge off Ratio 0.21 0.21 0.36 0.93 1.85 Average Return on Assets 1.11 1.04 0.77 -0.26 -0.78

Bank Holding Companies with Some Amount of TruPS in Capital Financial Ratios (%) 2005 2006 2007 2008 2009 Average Delinquency Ratio 1.24 1.15 1.77 3.14 5.13 Average Net-Charge off Ratio 0.24 0.22 0.33 0.73 1.55 Average Return on Assets 1.23 1.21 0.98 0.27 -0.28

Bank Holding Companies with No TruPS included in Capital Financial Ratios (%) 2005 2006 2007 2008 2009 Average Delinquency Ratio 1.20 1.05 1.59 2.83 4.31 Average Net-Charge off Ratio 0.15 0.15 0.23 0.54 1.17 Average Return on Assets 1.23 1.20 1.12 0.55 0.10 Source: SNL, Y-9C Reports; Based on Y-9C filers reporting as of June 30, 2010. High Dependence indicates TruPS exceeding 25% of tier 1 at any time during the period. Some Amount indicates a positive amount of TruPS, less than 25% of tier 1, during that period. No TruPS indicates no TruPS were included in tier 1 capital at all during that period. These ratios are unweighted averages.

11 Supervisory Insights Winter 2010 Trust Preferred Securities continued from pg. 11

these BHCs consist almost entirely of [company] Tier 1 capital is the fact the assets of their subsidiary banks. that cumulative preferred, the type of perpetual preferred most prevalent The BHCs that relied on TruPS in U.S. financial markets, normally were also much more likely to exhibit involves preset dividends that cannot concentrations in construction and be cancelled, but only deferred. An development (C&D) lending and to institution that passes dividends on be involved in non-traditional mort- cumulative preferred stock must pay gage lending. For example, roughly 70 off any accumulated arrearages before percent of BHCs with high dependence it can resume payment of its common on TruPS had C&D concentrations stock dividends. Thus, undue reliance over 100 percent of risk-based capital on cumulative perpetual preferred at some point during the past 5 years, stock and the related possibility compared to over 50 percent of BHCs of large dividend arrearages could with some TruPS, and nearly 40 complicate an organization’s ability to percent of BHCs with no TruPS. BHCs raise new common equity in times of with TruPS also held 99 percent of financial difficulty.”15 the volume of closed-end loans with negative amortization features during In retrospect, these words foreshad- that time period. owed issues that the banking agencies would have to confront during the This suggests that BHCs’ use of current crisis. As noted earlier, defer- TruPS correlated to some degree with ring dividends on TruPS does not their appetite for risk. For a given protect the accounting solvency of the level of tier 1 capital, having more organization and, when the interest TruPS and less equity acts to directly payments on the related subordinated boost ROE. Institutions whose ROE debt also are deferred, results in a focus was primarily short term, as build-up of a dividend arrearage that opposed to a focus on the sustain- accumulates at the stated dividend ability of earnings, may have been rate. In a situation where a capital motivated both to accept the higher injection into an open bank is being leverage implied by the use of TruPS, contemplated, the trust preferred and to invest in riskier portfolios. investors may not have incentive to Certainly, all the indicators cited in accept a reduction in their claims. Table 3 suggest that the portfolios of The FDIC’s experience has been the “high TruPS” BHCs were riskier that the holders of TruPS have been than the portfolios of other BHCs with an impediment to recapitalizations TruPS, and riskier still than the port- or sales of troubled banks. Potential folios of BHCs with no TruPS. investors in an open but troubled Obstacles to recapitalization. In bank may need some reduction in the preamble to a 1991 proposed claims from the TruPS holders to rule, the Federal Reserve wrote of the make a transaction feasible. However, issues that could arise from reliance there have been a number of occa- on cumulative preferred stock in a sions where, even when the common bank’s capital. “A principal reason for shareholders are poised to vote in the [Federal Reserve] Board’s deci- favor of a transaction or sale (even sion to limit the amount of perpetual one that results in significant dilution preferred stock in bank holding of equity), the trust preferred holders

15 See Notice of Proposed Revisions to Capital Adequacy Guidelines, 12 CFR parts 208 and 225, 56 Fed. Reg. 56949 (November 7, 1991).

12 Supervisory Insights Winter 2010 will not vote at all, or will not vote in that nearly 34 percent of the dollar favor of the transaction. One of the volume of trust preferred collat- problems is that many trust preferred eral that underlies the CDOs had issues are in pools, which the hold- either defaulted or deferred dividend ers say precludes voting on particular payments as of October 31, 2010.16 exchanges or discounts (e.g., BHC TruP CDOs are typically structured A offers to exchange its TruPS for into senior, mezzanine, and income common equity, or offers to redeem classes. Performance triggers, includ- its TruPS at a specified discount). In ing overcollateralization tests and some cases, the FDIC has found that interest coverage tests, are common downgraded TruPS are held by private features in these structures. These equity investors who purchased the triggers essentially act as a credit securities at a steep discount to par enhancement to the senior bonds. and may wish to hold out for a large When the overcollateralization perfor- “upside” in a transaction. In other mance test fails, cash flows are redi- cases, trustees of the TruPS will rected from the mezzanine bonds to not vote for fear of litigation, or the the most senior bond outstanding. percentage of TruPS holders needed With many of the TruP CDOs, over- to vote in favor may be very high. collateralization tests that govern the Losses to holders of TruPS. As mezzanine bonds have failed. Conse- noted earlier, TruPS fulfilled a dual quently, many mezzanine bonds are role for the banking system. Viewed now nonearning assets. as capital by the issuers, they Recovery rates on defaulted collat- carried tax deductible dividends and eral have been nonexistent during enhanced organizations’ opportuni- the banking crisis and cure rates on ties to boost ROE with leverage. deferring collateral have been mini- Viewed as debt instruments, and mal, with seven examples identi- often as highly rated instruments at fied where dividend payments have that, TruPS were permissible invest- been resumed since the banking ments for banks and grew to occupy crisis began.17 The high volume of an important niche in the investment nonperforming collateral means many portfolios of many of them. mezzanine bondholders are, or could Over 300 FDIC-insured institutions become, dependent on the securitiza- reported investment in TruP CDOs tion structure’s excess spread, mean- in their September 30, 2010 Call ing the difference between the interest Reports. Insured institutions typically generated from the collateral and that invested in the mezzanine classes. owed on the various bond classes. When issued, the mezzanine bonds The banking industry has expe- were rated investment grade. Today, rienced significant write-downs of they are typically rated Caa or worse mezzanine bond holdings. Over the because of the dramatic deterioration past two years, the failure of several in the underlying collateral. Fitch- federally insured depository institu- Ratings, which rates all the bonds tions was due largely, or in part, to in the TruP CDO universe, reported their investment in TruP CDOs.

16 “Fitch Bank TruPS CDO Default and Deferral Index,” November 2010, Structured Credit Special Report, FitchRat- ings. http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=576606. 17 Information based on conversation with ratings agency analyst.

13 Supervisory Insights Winter 2010 Trust Preferred Securities continued from pg. 13

The bottom line. It is difficult to disentangle the separate effects of Capital Reform higher imbedded financial lever- As became evident during the crisis, age, a higher credit risk profile and analysts and other market partici- increased difficulties with recapital- pants were ultimately looking to the ization that are associated with the tangible equity capital strength of issuance of TruPS. The experience banking organizations when assess- with bank failures during the crisis, ing their capital adequacy. This is however, points to the role that in part why U.S. bank regulators relying on TruPS to meet a portion did not allow TruPS to be included of their tier 1 capital requirements in the bottom line tangible equity had in producing weaker banking targets being established for the larg- organizations. est banks as part of the Supervisory As indicated in Table 4, banking Capital Assessment Program (SCAP) organizations issuing TruPS failed at conducted in the spring of 2009. much higher rates during the period The consensus of policymaking January 1, 2008 through November 5, groups reflecting on the financial 2010 than did insured banks gener- crisis has been that TruPS should ally or insured banks in BHCs that no longer be deemed tier 1 capital did not issue TruPS. In the table, for banking organizations. The Basel “No TruPS” refers to BHCs that did Committee on Banking Supervision not report any TruPS, “some TruPS” (BCBS) published a comprehensive refers to organizations with TruPS capital reform paper in December greater than zero and less than 25 2009, “Enhancing the Resilience of percent of tier 1 capital, while “high the Financial System.” That paper TruPS” refers to organizations with made a number of important propos- TruPS exceeding 25 percent of tier 1 als, many of which were ultimately capital at the beginning of that time agreed by the Committee and its period (or 25 percent of equity in the parent organization, the Group of case of small BHCs). More than 10 Central Bank Governors and Heads percent of the insured bank subsid- of Supervision. An important goal iaries of the Y-9C filing BHCs with of these Basel 3 reforms was to high TruPS issuance failed during this strengthen the definition of regula- period, almost three times the failure tory capital by moving much closer rate of insured institutions generally. to a “tangible common equity” approach. Part of this strengthening of the definition of capital included

Table 4 Cumulative Failure Rate, 1/1/2008 through 11/5/2010 Institution Group No TruPS Some TruPS High TruPS Larger BHCs (Y-9C filers) 3.2% 5.3% 10.5% Smaller BHCs 1.9% 6.2% 6.0% All insured institutions 3.6% Source: Y-9C Reports, YPSP Reports, Bank Call Reports, FDIC failure list. Based on active insured depository institutions as of December 31, 2007.

14 Supervisory Insights Winter 2010 phasing out, beginning in 2013, the Section 171 provides that the tier tier 1 capital treatment of TruPS and 1 capital treatment of TruPS issued similar hybrid capital instruments before May 19, 2010, by depository lacking the ability to absorb losses. institution holding companies with at least $15 billion in total consolidated In the U.S., in July 2010, Congress assets as of year-end 2009 will be enacted and the President signed the phased-out during a three-year period Dodd-Frank Wall Street Reform and starting January 1, 2013. TruPS of Consumer Protection Act of 2010 these organizations issued on or after (the Act). The Act had a number of May 19, 2010, would not be included important purposes, one of which was in tier 1 capital. to strengthen capital in the banking industry. Except as described in the next paragraph, BHCs with total consoli- Section 171 of the Act (generally dated assets less than $15 billion as referred to as the Collins Amendment of year-end 2009, and organizations after Senator Susan Collins of Maine, that were mutual holding compa- its sponsor) contains a number of nies on May 19, 2010, face the same important provisions, including that prohibition on the inclusion of new the generally applicable insured bank TruPS in tier 1 capital as do the capital requirements (and specifically larger organizations. The key differ- including the capital elements that ence for these institutions is that appear in the numerator of regulatory their pre-existing TruPS (those issued capital ratios) shall serve as a floor before May 19, 2010) are grandfa- for the capital requirements applica- thered: that is, Section 171 does not ble to depository institution holding require them to phase out these secu- companies. rities from their tier 1 capital. This part of Section 171 can be Finally, organizations subject to the viewed as affirming the concept that Federal Reserve’s Small Bank Holding bank holding companies should be a Company Policy Statement (which source of strength for insured banks. applies to most BHCs with assets less Specifically, bank holding companies than $500 million) are completely should not be a vehicle for achiev- exempt from any requirement of ing levels of financial leverage at Section 171. the consolidated BHC level that are impermissible for subsidiary banks. As It is anticipated that the require- TruPS are impermissible as tier 1 capi- ments of Section 171 restricting tal elements for insured banks, under BHCs’ ability to use TruPS to satisfy section 171 they would be (subject to tier 1 capital requirements would specified exceptions) impermissible as be implemented by Federal Reserve tier 1 capital for BHCs. regulation at some future date.

15 Supervisory Insights Winter 2010 Trust Preferred Securities continued from pg. 15

some, but will in the end result in a Conclusion stronger U.S. banking industry. The life of TruPS as a tier 1 capital instrument for large U.S. BHCs dates George E. French from birth in a 1996 Federal Reserve Deputy Director for Policy press release to a Collins Amendment- [email protected] mandated sunset at year-end 2015. Their 20 year lifespan was witness to Andrea N. Plante the full dynamics of both economic Senior Quantitative Risk and regulatory cycles. Analyst [email protected] Organizations took full advantage of the opportunity to issue subordinated Eric W. Reither debt as tier 1 capital, boosting ROEs Senior Capital Markets with tax deductible dividends and Specialist increased financial leverage. Institu- [email protected] tions that relied on TruPS for regulatory capital were financially weaker Ryan D. Sheller for it, took more risks, and failed Senior Capital Markets more frequently than those that did Specialist not. As is often the case after a crisis, [email protected] reforms were put in place to correct observed problems, and the elimina- This article benefited from the valu- tion of TruPS from large BHCs’ tier 1 able comments of Nancy W. Hunt, capital agreed by the Basel Committee Associate Director; Michael Kostrna, and required by the U.S. Congress is a Capital Markets Specialist; Gregory case in point. Moving away from reli- M. Quint, Capital Markets Specialist; ance on TruPS and towards real loss- Christopher J. Spoth, Senior Deputy absorbing capital will be manageable Director; Paul S. Vigil, Senior for most institutions, will challenge Management Analyst; and James C. Watkins, Deputy Director.

16 Supervisory Insights Winter 2010