TRuPs

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FDIC reviews role of trust preferred securities

One important theme of recent reforms in response to the financial crisis is the need for banking organizations to have stronger capital positions to weather periods of economic stress. As described in "Trust Preferred Securities and the Capital Strength of Banking Organizations" in the current issue of Supervisory Insights, released today, domestic and international legislative and regulatory reforms will end reliance on these hybrid securities and help move the U.S. banking industry to firmer footing.

"Evidence suggests that financial institutions relying on trust preferred securities had a heightened risk profile and failed more often than those whose tier 1 capital did not include these instruments ," said Sandra L. Thompson, Director, Division of Supervision and Consumer Protection. "The experience with these instruments helped set the stage for reforms mandated by the Collins Amendment to the Dodd-Frank Act and recent agreements by the Basel Committee for Banking Supervision that will strengthen the capital position of banking organizations going forward," added Director Thompson.

TRuPs buyback window open

A 90-day buy-back window for high-cost securities has been opened for banks as part of the Dodd-Frank financial reform changes.

Wall Street firms have the option of redeeming "trust preferred securities" - known as Trups – as they will no longer be registered as tier one capital, which is a central gauge of a bank's financial strength, from 2013 under the new regulations.

Around $118 billion of Trups may be reclaimed as the legal change allows issuers three months to redeem them at face value, reports the Financial Times.

Chip MacDonald from law firm Jones Day said: "Banks may find it desirable to redeem Trups but they have to think about what they are going to say to investors next time they want to raise capital."

Earlier this month, AIG stated that it may have to raise capital and limit its investments in private equity and hedge funds in order to comply with the rules of the Dodd-Frank Act, reported Bloomberg.

TruPs trading below par

One likely outcome of the Dodd-Frank financial-reform legislation is that it will rally the TruPS. Trust-issued preferred securities, or TruPS, are among a broad range of preferred-stock hybrids issued by companies to raise capital. For years, banks have relied heavily on TruPS to boost capital reserves — thereby increasing their ability to lend.

Typically, a bank creates an off-balance-sheet trust, which then issues preferred stock. The trust then uses the proceeds from the sale of the preferred shares to purchase subordinated debt from the bank, a strategy that essentially turns preferred stock into debt.

That's advantageous to a bank from a tax standpoint because unlike the dividends paid on preferred stock, the interest paid on bonds sold to the trust is tax-deductible.

Today, the average trust-issued preferred security is trading at 18% below its issuing price and is paying annual dividends of between 8% and 10%. The entire TruPS market is estimated to be valued at about $50 billion.

A rule change in the reform package aimed at forcing banks to strengthen their capital requirements will likely trigger billions of dollars in calls on TruPS over the next five years. Specifically, banks with more than $15 billion in assets will no longer be allowed to use TruPS in their capital calculations.

The banks have five years to replace TruPS with common stock or other securities that count as capital.

As a result, many holders of the securities will receive full, or par, value, in addition to the dividend income.

Small banks will be grandfathered, meaning that they are allowed to hold on to existing TruPS, but prohibited from issuing new ones.

At this point, it's unclear how much of the TruPS market will be in play over the next five years. But some financial advisers are already homing in on what they view as a rare opportunity to harvest income and capital gains through a relatively secure investment vehicle.

“It's a true opportunity because by 2016, all TruPS will be diverted out of the capital reserve,” said Mark Lookabill, an adviser with Carson Wealth Management Group, a $2.2 billion investment advisory firm. “We view it as a buying opportunity and an attractive investment option.”

A couple of recent examples of TruPS trading below their issuing price are Citigroup Inc.'s Citigroup Capital VI 6 7/8% Capital Securities (TruPS) Preferred Stock, which pays a 6% dividend and is trading at a 12% discount to par, and Bank of America Corp.'s Fleet Capital Trust IX, which pays a 6% dividend and is also trading at a 12% discount.

Of course, there is always the risk that banks will find other strategies to meet their reserve requirements that could reduce the chances of the securities' being called at par on schedule.

But considering banks' financial state these days, it seems unlikely they will be come up with a long list of capital-raising alternatives.

Then there's also the matter of why many TruPS are trading at steep discounts.

“The initial risk is whether the TruPS are any good to begin with, because if this is a preferred stock issued by a top-tier bank that is trading below par, you need to ask why it is trading below par,” said Mark Bowman, an adviser with Archer Private Financial Group LLC, an accounting and advisory firm.

Mr. Lookabill acknowledges that the market is discounting the securities, but he still likes the degree of risk relative to the yield and capital gains potential.

No matter what, money managers have long used preferred stock in both growth and income portfolios for the attractive and dependable dividend yields, plus the relative security of being just behind bonds on a company's capital structure.

“In some cases, preferreds will pay better yields than bonds issued by the same company, and they give us added flexibility in building out a fixed-income portfolio,” said Kenneth Winans, president of Winans International Investment Management & Research, which manages $138 million.

TRuPs CDO manager rights sold

Cohen & Co., the Philadelphia firm that built itself into the second-largest manager of collateralized debt obligations, is selling its contracts to oversee CDOs backed by bank capital notes.

A Fortress Investment Group LLC affiliate bought the management rights on $3.8 billion of Alesco CDOs backed by trust-preferred securities, or TruPS, for $5.4 million, Cohen & Co. said yesterday in a Business Wire statement. The Fortress affiliate also agreed to buy the contracts on $3 billion more for $4.1 million, pending approval of certain equity holders.

Cohen & Co. grew to manage almost $32 billion in CDOs that held TRuPS, subprime-mortgage bonds and other assets, by Sept. 30, 2007, before the collapse of such funds helped create a global financial crisis, according to Standard & Poor’s. Hedge fund Hildene Capital Management LLC last year attempted to fire the firm from managing TruPS CDOs, citing conflicts of interest between the business and its brokerage and advisory unit.

The company announced a series of steps yesterday that “are significant developments in providing our firm additional resources for the future of our growth businesses,” Chairman and Chief Executive Officer Daniel G. Cohen said in the statement.

James Golden, a spokesman for the company, couldn’t immediately provide comment. Gordon Runte, a spokesman for New York-based Fortress, didn’t return a telephone message today.

Cohen & Co. may also be paid as much as $12 million more for the Alesco CDO contracts, depending on the amount of defaults and prepayments, according to the statement.

Alesco CDOs

ATP Management LLC, which is affiliated with some of New York-based Fortress’s investment funds, will pay Cohen & Co. as much as $23 million for services related to the deals, the firm said.

The Alesco CDOs generated 40 percent, or $2.5 million, of the company’s asset management revenue in its fiscal second quarter, according to the statement yesterday. CDOs package assets into new securities with varying risks.

A Cohen & Co. unit was “one of a number of market participants to receive a subpoena from the SEC seeking documents and information in an investigation titled In the Matter of Certain CDO Structuring Sales and Marketing Practices” in June 2009, the company said in a March filing with the Securities and Exchange Commission.

“After our dispute last year, Cohen implemented a new system that proactively contacted investors about developments and we considered it to be very investor-friendly,” John Scannell, New York-based Hildene’s chief operating officer, said today in an e-mail.

Losses Sparked

Trust preferred securities have a combination of debt and equity characteristics. They are issued by trusts formed by companies raising cash. Banks count the notes as capital while considering the interest payments tax-deductible.

A total of 31.1 percent of bank TruPS in CDOs were either deferring payments or in default as of June, as U.S. lenders grapple with loan losses sparked by the deepest recession since the 1930s, New York-based Fitch Ratings Inc. said in a July 20 report.

A different Fortress affiliate, TP Management, assumed oversight of Taberna CDOs earlier this year from a unit of Philadelphia-based RAIT Financial Trust, whose chairman is Daniel’s mother Betsy Cohen and where Daniel served as CEO from December 2006 through February 2009. The Taberna CDOs contain TruPS sold by real-estate companies, real-estate investment trusts and lenders.

Chris Ricciardi

Chris Ricciardi, Cohen & Co.’s president, joined the firm in 2006 after leading Merrill Lynch & Co.’s top-ranked CDO underwriting business, and heads its broker-dealer division. He said on a May 7 conference call that it recently began originating and distributing certificates of deposits, and had hired a team to broker equity derivatives between dealers. New businesses might include municipal and emerging-market debt, he said.

TCW Asset Management Co., based in Los Angeles, was the largest CDO manager before the market collapsed, overseeing $41.3 billion of the funds, S&P said. CDO managers are often used to select the initial collateral for the vehicles, sometimes trading and replacing the assets over time.

Hildene said in an October letter to the trustee of four CDOs managed by Cohen & Co. that the CDO manager’s intent in seeking to change certain terms of its contract may have been to win business for its securities arm that helps banks retire TruPS at a discount.

Credit Facility

Cohen & Co. also yesterday announced a new credit facility for its Dekania Investors LLC unit and a tender in which it’s offering to pay 80 cents on the dollar for $9.5 million of subordinated notes issued by Cohen Brothers LLC.

Cohen & Co. rose 18 cents, or 3.7 percent, to $4.99 in NYSE Amex trading as of 4:15 p.m. in New York. Shares have climbed 1.8 percent this year. The stock is down from $117.50 in January 2007 when the company was named Alesco Financial Inc., a real estate investment trust managed by a Cohen & Co. unit, which merged with Alesco Financial in December. Fortress declined 19 cents, or 5.1 percent, to $3.52 in New York Stock Exchange composite trading.

Alesco Financial was created in 2006 when Sunset Financial Resources Inc. bought a Cohen-managed real estate investment trust called Alesco that invested in assets including the lowest-ranking portions of Cohen-managed CDOs.

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