The Collins Mixer
Republican Susan Collins proposed an amendment to tighten bank capital reqirements. It passed unanimously, but might be removed in conference because the Obama Treasury is opposed. The world is upside down. One key issue is whether banks can use “Trust preferred securities” to
evade satisfy capital requirements.
After the jump, I will ask the wikipedia to explain (yes I use the wikipedia and I’m not ashamed to admit it – OK I am ashamed but I admit it anyway). The bottom line is “They got away with doing thant !?!?!” Note US Democrats are fighting Europeans and Collins to keep the loophole open.
So Ms Wikipedia, what is a Trust-Preferred Security ?
The issuing company forms a Delaware trust (a Connecticut trust is also common) and holds 100% of the common stock of the trust. The trust then issues preferred stock to investors. All of the proceeds from the issuance of preferred stock are paid to the company. In exchange, the company issues junior subordinated debt to the trust with essentially the same terms as the trust’s preferred stock. All steps except the formation of the trust occur simultaneously. If the issuing company is a bank holding company, it will also usually guarantee the interest and maturity payments on the trust preferred stock.
OK so it is preferred stock with a full faith and trust guarantee on the payments – that is to say debt. What’s the point Ms Wikipedia?
if they are issued by a bank holding company, they will be treated as capital (equity/own funds) rather than as debt for regulatory purposes. This is why trust preferred securities are issued overwhelmingly by bank holding companies,
That’s a joke right? They can’t possibly get away with that can they? Of course that answers the question of what is the special purpose of the special purpose entity. I think the point is that, if a bank issued preferred shares and guaranteed payment on those preferred shares, then it would be too obvious that the shares are debt for regulators to pretend not to notice.
This is an absurd scam, but recall, our US government is arguing that it is OK. And a Republican (who isn’t even named Snowe) called BS.
I need a drink. Make it a collins.
Brad DeLong has said that you want Tim Geithner on your side because he’s and he’ll fight for you. Brad just has yet to realize whose side Geithner is really on.
I keep saying that both parties are stupid. It has been downhill for some time.
If I can add a little more to the knowledge base here?
The crucial distinctions in what is Tier 1 capital and what is not come not (at least not usually) from US law but from international law. Basel I and II (and no doubt soon Basel III). And in the Basel treaties the crucial distinction between what counts as capital and what counts as debt is not, as above, the more usual distinction between capital and debt.
It’s the maturity of the debt. OK, I’m going to the limits of my own knowledge base here, but essentially, debt which has no maturity date, ie, permanant debt rather than 5, 10 or 50 year bonds, counts as capital, debt which has a maturity date does not.
Many of the British banks issued Perpetual Floating Rate Notes for example. These Trust Preferred Securites seem to me to be similar. As lonmg as they are perpetuals, as long as there is no date at which they must be redeemed, then they’re capital (although there are still limist on how much of the qualifying capital can be made up of these debt structures).
Now, whether this is a sensible thing for a bank to be doing is quite another thing. But I would just note that opposing a change in the law, a change which would ban such things, sounds sensible. For one of the things that people are truly worried about is regulatory arbitrage: doing different things in different jurisdictions because one can. So, whatever we have as the bank capitalisaqtion rules should be the same wherever the bank is….which is why we have Basel in the first place.
tim w is more or less correct here.
junior preferred securities are considered hybrid debt / equity securities. you can think of them as very junior debt or senior equity, but to paint them just as ‘debt’ is wrong. for instance fannie and freddie have a lot of junior prefs and these are not being guaranteed by the government. (they are currently trading at 4-5 percent on the dollar — optimists such as me think that there is a decent chance that fnf will recover and the junior preferred debt will be paid out.)
there are a bunch of restrictions on what can be used as tier 1 capital — maturity is one thing which tim w alluded to — i am not sure of the exact rules but for preferred debt to be usable as regulatory capital it needs to be “non-cumulative” which is a fancy word for “if it is necessary the issuer can missed payments indefinitely without breaching any agreement and don’t have to make up missed payments”. (issuers need to resume dividend payments to prefs before resuming them to common stock.)
so these instruments work well for regulatory capital in that they are ‘optional’ obligations and protect the debtholders. what’s not to like?
Ah, non cumulative, yes, that makes sense as well…..
Interesting stuff guys.
Ignoring “hybrid” preferreds where the issuer makes up custom rules, preferreds always place a time limit of 20 quarters on missed payments at which point they are technically in default. Not indefinite! Now nearly all TruPS are cumulative, so that missed back payments must be made up. Clearly non-cumulative traditional preferreds are a nicer form of “capital” for banks under stress.
Tim’s point about maturity & Tier I is interesting, but I found a little odd that when push came to shove in early 2009, we threw the Tier I standards out the window and focused only on Tangible Common Equity. The idea (in my limited understanding) is that this is risk capital where the investor does not have any contractual entitlement (to be resolved in bankruptcy court).
Back to trust & traditional preferreds, there is an entitlement to bankruptcy court, but it seems to me that 20 quarters or 5 years is a heck of a grace period even when the dividends are cumulative. Surely this is tremendously more flexible than debt of any sort.
I only know what I read in the Wikipedia, but it described “maturity” payments so it sure sounds like the securities mature. The Wikipedia says they are very long term — 30 years or more. So it sounds to me as instruments with a maturity date count as equity.
Of course the Wikipedia is not edited, so it is not reliable. And I know basically nothing about trust preferred securities.
Again all I know is what I read in the Wikipedia. The part that shocked me (which might be innacurate) is “If the issuing company is a bank holding company, it will also usually
guarantee the interest and maturity payments on the trust preferred stock.” which sure sounds cumulative to me.
But I might have missunderstood and the Wikipedia isn’t edited.
Thanks for the information. I didn’t know about the grace period (I just new “guaranteed”). As far as I can guess, the grace period isn’t necessarily all that huge an issue. If a bank has issued a lot of TruPS out then potential bon buyers know that, in case of bankruptcy, their claim will be diluted. A failed bank isn’t going to be able to use the grace period, and a bank purchasing the failed bank from the FDIC will have to honor the TruPS. So they won’t themselves drive a bank into failure quickly or really ever (there is no way it survives 5 years not paying on TruPS). But fear of the TruPS claims will make it harder for the bank holding company to sell bonds (or borrow from other banks).
Seems to me that if something is cumulative, it should be counted as debt not equity. Long term with a long grace period, but still not zeroed out in case of failure, means it is a big problem for a bank holding company in trouble.
I don’t want to bore people repeating the obvious, but I’m ignorant.