Trust Preferred Stocks - Why Not Just Issue A Bond?

There are three types of preferred stocks – traditional preferred stock, trust preferred stock and third-party trust preferred stock (see pages 31-35 of Preferred Stock Investing). From the investor’s perspective, there is very little difference. The difference exists to accommodate various reporting needs of the issuing company.

Enron made Trust Preferred Stock (TPS) famous by taking advantage of a loophole (closed in 2003). Now, for reasons that I will explain in a moment, only banks issue TPS’s.

When a company issues a Trust Preferred Stock (TPS), they first set up a new company (the trust). That trust sells the TPS shares to the investing public and loans the proceeds back to the issuing (parent) company. The issuing company, in exchange for this loan from the trust, issues a bond (usually a “junior subordinated debenture”) to the trust, which is a promise to pay back the loan plus interest.

Since the issuing company has to issue a bond to the trust, why bother issuing a TPS in the first place? Why not just issue the bond directly to the investing public and forget about the complications involved with setting up the trust and all of the recordkeeping that goes with it?

Here’s why: As the issuing company makes interest payments to the trust, the trust uses that cash to pay dividends to the investors who purchased the TPS shares from the trust. The trust is essentially a middleman, collecting cash interest payments from the issuing company and passing that cash on to investors in the form of dividend payments. The IRS collects taxes from the trust on the interest income that the trust received from the issuing company...unless the issuing company locates the trust offshore beyond the reach of the IRS in, say, the Turks & Caicos (think Enron here). Bingo, no taxes.

Also, reporting the TPS as “equity” on the company’s books, along with other common and preferred stocks, boosts the company’s all important “debt-to-equity” ratio, making the company’s SEC filings look more attractive to investors.

So TPS’s provided a double benefit – lower taxes plus stronger SEC filings.

New accounting rules in 2003 closed these loopholes. The issuing company is now required to pay taxes on the interest payments sent to the trust and the TPS shares issued by the trust are now required to be reported as a liability on the parent company’s books rather than as equity.

But a remaining disparity still benefits banks, specifically. Bank regulators watch a variety of metrics to assess bank health. “Tier 1 Capital” is a calculation that includes preferred stocks, including TPS’s. From this perspective, issuing a TPS allows a bank to raise capital plus boost their Tier 1 Capital metric, keeping regulators happy.

But regulators also keep an eye on another metric called “Tier 1 Common Equity” which includes common stock shares but, unlike Tier 1 Capital, does not include the value of preferred stocks that the bank has issued. When regulators changed their emphasis to Tier 1 Common Equity for TARP banks earlier this year, TARP banks began converting their outstanding preferred stocks (including trust preferred stock shares) to common stock shares, boosting Tier 1 Common Equity into the land of respectability in the eyes of bank regulators. Had banks issued bonds instead of TPS’s, they would not have had this option.

Trust preferred stocks provide banks (and, now, only banks) with a measure of flexibility that bonds do not when it comes to satisfying their regulators. For this reason, trust preferred stocks will continue to be issued by banks (and no one else). Thanks to subscriber Don L. for submitting this question.

Many Happy Returns.