Financial Reform May Create New Low-Risk Preferred Stock Type

The Financial Reform Bill currently being debated by the legislature includes what is being referred to as the Collins Amendment as introduced by Maine Republican Susan Collins. The amendment seeks to end a bank's ability to issue a Trust Preferred Stock (TRUPS; one of the three types of preferred stocks, see page 33 of Preferred Stock Investing).

Here’s why I think that the Collins Amendment could very well give birth to a new type of low-risk preferred stock, specifically from regional banks.

It is harder for small banks to issue TRUPS on their own because investors view securities from such small banks as higher risk, requiring the small bank to sweeten the deal. The added costs associated with doing so make issuing TRUPS cost-prohibitive for small banks. But by bundling a bunch of small bank TRUPS with large bank TRUPS into a single security called a Collateralized Debt Obligation or CDO, the risk is averaged out (very similar to how a mutual fund works).

The Wall Street firms that create these TRUPS-based CDOs are then able to go back to the investors with a lower-risk security hence lowering the associated costs for all involved. For small banks, these TRUPS-based CDOs provide them with lower cost access to investor capital that they would otherwise not have available to them. In the end, the cost-lowering effect of the TRUPS-based CDOs lowers the barrowing cost for regional borrowers (such as small business owners and homebuyers) as well.

By creating TRUPS-based CDOs, Wall Street created a useful mechanism for smaller banks to access the otherwise out-of-reach capital needed to meet regional loan demand. I heard Federal Reserve chairman Bernanke testify that this “securitization” (creation of CDOs) accounts for 40% of the funds used to finance mortgages in the United States. TRUPS, and TRUPS-based CDOs, have worked as intended, providing low-cost access to capital for small banks. The problem is not (and never was) with TRUPS, nor with CDOs per se. The problem entered when TRUPS-based CDOs were allowed to be purchased by other banks.

In order to prevent just the type of domino-effect “downward spiral” that this Bloomberg article describes, banks are not allowed to buy each other’s equity (stock). They can buy each other’s debt (like bonds), but one bank cannot become a part-owner of another bank by buying its equity (stock, common or preferred).

But for the reasons that I discussed in this October 1, 2009 post, 2003 legislation required that banks classify TRUPS as debt rather than equity. Since TRUPS are no longer considered equity, banks have been allowed to invest in each other’s TRUPS and TRUPS-based CDOs.

The cash that holds it all together, of course, comes from the borrower’s monthly loan payments. As long as borrowers continue to make their loan payments every month, it’s a win-win all around. But when the Federal Reserve started increasing interest rates to ward off inflation in mid-2004 (see CDx3 Key Rate Chart, Preferred Stock Investing page 56), Adjustable Rate Mortgages issued to subprime borrowers adjusted dramatically upward three years later, and in mid-2007 these borrowers started defaulting on their loans.

Downward spiral here we come; the first domino upon which all others depend had been tipped.

When smaller banks started missing interest payments on their TRUPS, the CDOs composed of those TRUPS stopped making interest payments to shareholders which, under the 2003 reclassification legislation, were mostly other banks. Had those banks been prohibited from investing in TRUPS-based CDOs (as is the case with bank-issued equity), the cascading crisis, at least in this regard, could not have happened.

The Collins Amendment, by eliminating TRUPS, may solve the domino problem but risks shutting off this valuable, low-cost funding instrument to small banks. It seems that there are a number of ways of fixing this including extending the existing prohibition on banks investing in one another to include TRUPS-based CDOs. While I would guess that legislative leaders have looked into this seemingly simple solution, the financial press has not discussed it.

Whatever the case, the need that banks have for capital to satisfy regional loan demand does not change; what we are talking about here is how that need should be most safely and affordably satisfied. While we may see additional restrictions or even the elimination of TRUPS or CDOs as we know them, the vacuum must be filled with some other type of provision, perhaps even a new type of preferred stock that is specific to the banking industry used just for this purpose.

It will be very interesting to see how the legislature meets the requirements for small banks to access capital for loans, but avoids the domino-effect structure that we now have. We could very well see a new type of preferred stock emerge from this discussion; one that can be issued by small banks at low cost and at low risk to investors (us) in response to regional loan demand.

Many Happy Returns.