Trust Preferred Returns: Dodd-Frank Offers An Interesting Opportunity

Includes: AIG, BAC, C, CFC.PB, GS, MS
by: Joe Eifrid

A possibly quite profitable trading opportunity in exchange traded Trust Preferred (TRUP) shares has developed. These TRUPs are subject to a possible early call as a result of the occurrence of a Regulatory Capital Event stemming from the provisions of the Dodd- Frank Wall Street Reform Act which no longer allows these banks to include the funds originating from these securities as Tier 1 capital on their balance sheets. If you follow the banks you know that Tier 1 capital levels are very important to them. The banks have a strong incentive to redeem these TRUP shares early. TRUPS issued before May 19, 2010, by larger banks (over $15 billion in assets) will continue to be treated as Tier 1 capital until January 2013. At that time, the Tier 1 capital treatment will be phased out over a three-year period ending in January 2016. First Third Bank (NASDAQ:FITB) and Key Bank (NYSE:KEY) have already called and redeemed some of their TRUPs prior to their contractual maturity date. Rules vary for smaller banks.

Not familiar with TRUPs? Neither was I until 2008. Preferred shares are usually thought of as being boring. I have found them anything but during times when economic circumstances are weighing on the financials, as currently. TRUPs trade thinly and during these times uncommon values can be found. TRUPs have symbols and can be traded easily along with common stocks.

A TRUP is a hybrid security possessing characteristics of both equity and debt issues. A bank creates trust-preferred securities by creating a trust issuing debt to the new entity, while the trust issues the TRUP. The security is a hybrid security with characteristics of both subordinated debt and preferred stock. Unlike traditional preferred shares, TRUPs are backed with a debt security. TRUPs issued by a bank-holding company will be treated as capital (equity/own funds) rather than as debt for regulatory purposes. This is why trust preferred securities have been preferred overwhelmingly by bank-holding companies. Since these preferreds derive their dividend from the underlying interest paid on the debenture, the dividends are taxed as interest. When redeemed or "called", similar to bonds TRUPs are repaid the original face amount. Most TRUPs are issued with a $25 face value and pay dividends quarterly.

The Trade Strategy

First one needs to identify TRUPs for banks with over $15 bil in assets that have TRUPs selling below their usual face value of $25. The plan is to collect dividends until they are prematurely called and then receive the difference between the called value (face amount) and the purchase price you paid. One may have to wait until 2016 to get called but it appears there may be incentives to call these TRUPs prior to January 2013, the way FITB and KEY did. Why pay above market interest when Dodd – Frank gives them an out? is one place to find a list of TRUPs. Several banks list TRUPs obtained through mergers. For example, Bank America (NYSE:BAC), beside holding its own, has acquired one of the more interesting TRUPs that I follow. That TRUP was issued by Countrywide Mortgage. I know, I know, that sounds scary. However, few know that several months after BAC acquired CFC, BAC issued a statement with BAC guaranteeing the CFC TRUPs, making them equal to the BAC TRUPs. Though “rattling the sabre” toward all the CFC claimants of their ability to bankrupt Countrywide, it appears that it might be too late to separate much of the components of the two institutions.

Symbols for preferreds can be tricky from one brokerage to another. Schwab’s trading platform has the CFC series B TRUP listed as CFCpB. On the site it appears as CFC+B. shows it as CFC-B. Yahoo quotes you would need to type in CFC.PB. Check with your broker about how they handle the symbols for preferreds. For this example I am going to use the security symbol CFC-B which is the symbol used by TDAmeritrade and many other brokerages.

CFC-B traded at $20.00 a share on Monday the 10th. CFC-B has a dividend of 7% - $1.75 per year (.4375 per quarter), giving a yield of 8.75%. The desired scenario for this strategy is to collect the $1.75 dividend until BAC calls this TRUP in. If it were to be called in five quarters in January 2013 we would have collected five dividend payments for a total of $2.19, plus redemption at $25 per share for another $5 (we paid $20 per share) for a total return for that year and three months of $7.19, or a 36% return. Of course if it waits until 2014 to call in those shares, our return ‘per year’ would be smaller but we would also receive another year’s worth of dividends – a total of $3.94 in dividends and the $5 gain from our cost of shares for a total return of 44.7%. Nice to get paid while we wait!

Keep in mind that trust preferred securities issued by bank holding companies can allow for the deferral of interest payments for up to 5 years. Unlike the traditional preferred stock, dividends of the Trust Preferred shares accumulate, so there is not much incentive to defer unless they are very short on cash. They also have restrictions with deferrals that are not comfortable to the banks. Typically, during the deferral or extension period, the Bank Holding Company is not permitted to declare or pay any dividends or distributions on—or redeem, purchase, acquire, or make a liquidation payment with respect to—ANY of its capital stock. In addition, they are not permitted to make any payment of principal, interest, or premium, if any, or repay, repurchase, or redeem any debt securities that rank pari passu with or junior in right of payment to the debentures.

Recently I wrote BAC’s investor relations department and asked when they may start calling in shares (like they are really going to tell me), and if all the TRUPs they have would be subject to Dodd-Frank. This is the email reply I received;

Predominantly all of the Bank of America Trust Preferreds securities would be subject to this phase out. There are a number of factors we consider in assessing our funding profile and whether to exercise call options on individual securities. These factors may include the size of an issue, remaining term, capital treatment, asset-liability mix and funding profile, investor base, market conditions, regulatory considerations and economics.

CFC-B and its cousin CFC-A typically sell at a deeper discount to the other BAC TRUPs although S&P ranks them the same as the others. AIG has a couple of interesting TRUPs listed as ‘third party’ TRUPs under symbols MKS and XFP. Both of those are investment grade rated and yielding currently about 8.8%.

Of course there are risks. You will find most of the TRUPs that are selling enough below $25 to make the redemption attractive are securities listed under Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), Citigroup (NYSE:C) and BAC. In my opinion these banks will want to redeem. In most instances they are making interest payments on these issues above where they could currently borrow, and once they are no longer treated as Tier 1 capital they have little use on the balance sheet.

By 2016 there should only be a few TRUPs still available. In the meantime I believe we will see many opportunities to profit from their early redemptions as suggested by Dodd – Frank.

Disclosure: I am Long CFC.A, CFC.B, XFP, MKS