Jason Cave

Trust Preferred SecuritiesTrust Preferred Securities

OverviewOverview

• Introduction to Trust Preferred Securities (TPS) and Other Hybrid Capital Instruments

• Issuer Considerations– Benefits– Risks

• Investor Considerations – Benefits – Risks

• Accounting Issues Relating to TPS• Proposed Guidance for Hybrid Capital

Instruments

Trust Preferred Securities (TPS)Trust Preferred Securities (TPS)

• XYZ is a bank or thrift holding company, establishes a grantor trust (the “Trust” whose sole purpose is to issue Trust Preferred Securities.

• XYZ will acquire 100% of the Trust’s common shares with a liquidation value of at least 3% of the Trust’s total capital.

• The Trust issues $10 million in Trust Preferred Securities to the investor. To the extent that the Trust has received sufficient funds from XYZ, XYZ will guarantee on a subordinated basis that the Trust Preferred Securities holders will receive interest and principal payments.

• The Trust lends the proceeds from the issuance of Trust Preferred Securities to XYZ in return for Junior Subordinated Debt Securities with terms matching those of the Trust Preferred Securities. The Junior Subordinated Debt Securities rank subordinate to all other senior debt of XYZ but senior to XYZ’s preferred and common stock.

• The Trust will distribute the interest it receives on the Junior Subordinated Debt Securities to fulfill its payment obligation on the Trust Preferred Securities.

• The Trust Preferred Securities will mature in 30 years and are callable at the option of XYZ in 5 years. Interest can be deferred for up to 5 years.

Bank Trust Preferred Securities are hybrid capital instruments that combine attributes of debt with features of equity, resulting in hybrid capital instruments that are treated as debt for tax purposes and as Tier 1 capital at a Bank Holding Company for regulatory purposes under current U.S. laws and regulations.

XYZ Bank Holding Co.

Trust

Investor

$10.0 MMCash

Trust Common Shares

$10.3 MM Junior Subordinated

Debt Securities

$10.0 MMPrincipal Amount

Trust Preferred Securities

$10.3 MM Cash

$0.3 MM Cash

Source: Merrill Lynch

Example: $10 million of Trust Preferred Securities Issuance

How Big Is The Market?How Big Is The Market?

TPS Penetration as of June 30, 2004

876 Total BHC Issuances

0

500

1000

1500

2000

2500

Nu

mb

er o

f H

old

ing

Co

mp

anie

s

Holding

companies

under $500M

Holding

companies

>$500M<$1B

Holding

companies

>$1B

All Institutions

Holding Company Asset Size

Total Holding Companies Holding Companies issuing TPS

TPS Current Market ActivityTPS Current Market Activity

• Substantial “Refunding” Activity

– Issuers taking advantage of 5-year call due to low interest rate environments

• Recent issuance predominantly variable rate

– 3-Month LIBOR is most common index

• Approximately 300 basis points to 3-month LIBOR for smaller community bank deals

Example of Refunding Activity Example of Refunding Activity

• Issuer: Enterprise Financial Services

• CUSIP #: XXXXXXXXX

• Issue Date: x/xx/99

• Par Amount: $XXX

• Dividend: 9.40%

• Callable: XXX

• Issuer: Enterprise Financial Services

• CUSIP# XXXXXXXXX

• Issue Date: 12/13/04

• Par amount: $XXX

• Dividend: 4.42%

• Step-up: 3-mo. LIBOR + 197 bp

• Callable: 2009

Issuers taking advantage of 5-year call due to low interest rate environment

Source: SNL Financial LC

2003 Bank Holding Company Issuance of Hybrid Capital 2003 Bank Holding Company Issuance of Hybrid Capital InstrumentsInstruments

Source: Keefe, Bruyette & Woods

The 1996 FRB Capital InterpretationThe 1996 FRB Capital Interpretation

• Allows BHC to count TPS as a form of Tier 1 capital

• Instruments had to be long-dated (generally original maturities of 30 years or more)

• Allowed for a minimum of 5 consecutive years of payment deferrals

• Was subject to regulatory approval before it could be called or redeemed and

• Was structurally subordinated to all other debt• Generally limited to 25% of Tier 1 capital• Banks not allowed to issue TPS as Tier 1

Fed - Proposed Guidance Fed - Proposed Guidance

• Issued in response to changes in accounting standards for TPS – FIN46.

• Allows for the continued inclusion of TPS in the Tier 1 capital of bank holding companies.

• Revises the quantitative limits on the aggregate amount of cumulative perpetual preferred stock, TPS, and minority interests in the equity accounts of certain consolidated subsidiaries to 25% of Tier 1 capital, net of goodwill. 15% for internationally-active institutions.

• Revises the qualitative standards for capital instruments included in regulatory capital.

• Generally more conservative than existing standards.

On May 7, 2004, a Notice of Proposed Rulemaking (NPR) was issued by the Fed for Bank Holding Companies:

Summary of Comment Letters – Summary of Comment Letters – Fed’s NPRFed’s NPR

General Comments:

• Opposed the proposed reduction in the amounts eligible for Tier 1 capital recognition.

• Opposed the further deduction of goodwill in calculating the proposed 15% limit.

• Requested a 5-year transition period be provided in any final.

• FDIC Comments:

• Recommended phasing out recognition of TPS as Tier 1 capital. After the transition period, the instruments would receive only Tier 2 capital treatment.

• Suggested that an interagency review of other hybrid capital instruments at the bank level and an ANPR soliciting comment on the attributes of the instruments that provide meaningful capital support should be completed expeditiously.

TPS – Issuer BenefitsTPS – Issuer Benefits

• Holding company can obtain lower cost of regulatory capital.

– Interest payments on the TPS are deductible for federal income tax purposes.

– More cost-effective form of Tier 1 capital than common or preferred stock.

– 5-year call allows reissue option

• Performance ratios are enhanced.– TPS are non-dilutive to existing shareholders.

TPS-Issuer Benefits (cont’d)TPS-Issuer Benefits (cont’d)

• First Midwest Bancorp ($6B in assets) issued $125 million at 6.95%.

• The after tax cost of capital(35% tax rate)= 4.5%

• Compared to returns of equity requirements of 12-15%, TPS financing is an attractive alternative to common and preferred stock.

• TPS considerably more expensive than senior debt and deposits.

Issuer BenefitsIssuer Benefits

• Proceeds used to retire more expensive forms of capital-common and preferred stock

• Valuable acquisition currency – $1.1 billion Southern Community bought

Community Bank of Pilot Mt, NC in January, after selling $34.5 million of TPS in November

• Fund branch mergers and acquisitions

Supervisory ConsiderationsSupervisory Considerations

• Has the bank developed a well thought out strategy for deploying TPS proceeds?

• Does the bank understands the terms, conditions, and obligations associated with TPS financing?

• Why does a bank with a 16% leverage ratio need more capital?

• Small bank holding companies reliance on TPS on the rise

Reliance on TPSReliance on TPS

23%20%

14% 14%

0%

10%

20%

30%

40%

50%

Tie

r 1

Ca

pit

al

Holdingcompanies

under $500M

Holdingcompanies>$500M<$1B

HoldingCompanies >

$1B

All Institutions

Holding Company Asset Size

TPS as a Percentage of Tier 1 Capital

June 30, 2004

TPS-Investor BenefitsTPS-Investor Benefits

• Attracted to the high yields associated with TPS. For example:

– TPS (SAL Trust Pfd. I) – 9.11%*

– 5-Yr. FHLB bond (Atlanta) – 4.01%*

– 30-Yr. U.S. Treasury bond – 5.17%*

• TPS are permissible investments for banks- OCC considers TPS as “debt”

• Banks have become active purchasers of TPS.

*Source: Bloomberg

Investor RisksInvestor Risks

• Credit Risk– Deeply subordinated, long term debt– Non earning asset if BHC defers dividends

• Interest Rate/Market Risk– Issuer has the option of calling investment at year 5,

or in some cases, extending to year 45. Option/reinvestment risk

• Liquidity Risk– Thinly traded, generally illiquid, wide bid/ask spreads

• Examiners should expect banks to perform a considerable amount of prepurchase and ongoing analysis on TPS investments.

Comparison of Default Recovery Estimates Comparison of Default Recovery Estimates for Various Claimsfor Various Claims

TPS Falls Here

Systemic IssuesSystemic Issues

• Concentration risk

• Banks purchasing BHC equity

• Risks retained within the banking system.

Pooled TPSPooled TPS

Definition: A collateralized debt obligation (CDO) whose interest and principal payments are linked to the timing of default losses of a pool of underlying TPS.

• Considered cash flow CDOs

• Excess spread, OC, and wraps used as credit enhancement

• Early amortization triggers

• Key to deal: place the equity piece 0

10

20

30

40

50

60

70

80

90

10060% of CDOAAA-RatedL+75 to 100

Bps

32% of CDOAA to BBB-

RatedL+175 to

375

8% of CDOUnrated

15% to 20% ROE

Senior

Mezzanine

Equity

Source: KBW

TPS CDO MarketTPS CDO Market

• Total deals – approximately 36

• Over $16.4B in securities

• # of issues in all pools: 1600-1800 (including insurance companies)

Source: FitchRatings

CDO - Issuer BenefitsCDO - Issuer Benefits

• Opens market access to smaller players – Shared issuance costs

• Down from 3% to 1% per issuer

– Diversified collateral pool– Potentially lower funding costs

• LIBOR + 300 basis points

• Small banks gain access to the same benefits that were previously limited to large banks

CDO – Investor BenefitsCDO – Investor Benefits

• Higher AAA-rated yields than in most ABS markets

– AAA-rated spreads at 50 to 100 basis points above 3-month LIBOR

– AAA-rated quality credit card spreads at 10 to 20 basis points above 1-month LIBOR

• Diversified collateral pool and Typical ABS Structural Credit Enhancements

• Structured to meet investor maturity and risk appetites

• Favorable regulatory capital treatment higher rated tranches

CDO RisksCDO Risks

• Credit Risk– Pooled nature potentially reduces credit risk

exposure to individual names– Dependent upon tranche purchased

• Market Risk– Senior and mezzanine tranches– Spread widening– Embedded option risks– Extremely difficult to value

• Liquidity Risk– Primarily a private placement market– Lack of a secondary market – Relatively new product

Newly Issued Pooled TPS- Newly Issued Pooled TPS- Sample ProspectusSample Prospectus

• Issuer: ALESCO Preferred Funding II, Ltd.

• Assets: Trust preferred securities, secondary trust preferred securities and bank subordinated debentures

• Tenor: 30 years

• Maturity Date: January 30, 2034

• Auction Call Date: January 30, 2014

• Weighted-Average Spread of Floating Collateral: 2.83%

• Weighted-Average Coupon of Fixed Collateral: 7.36%

Ratings InformationDeal Summary

Source: FitchRatings

ClassAmount

($Mil) Rating Size (%) Rated Coupon (%)A-1 150 AAA 43.03

3M LIBOR + 0.58%A-2 66 AAA 18.93

3M LIBOR + 1.10%B-1 64.3 A 18.45

3M LIBOR + 1.65%B-2 40 A 11.47

3M LIBOR + 1.65%Preferred Shares 28.3 NR 8.12 -----

348.6 100

Ratings MethodologyRatings Methodology

• The quality and mixture of the portfolio’s assets: concentration risk.

• The credit enhancement provided to the levels of outstanding debt.

– Achieved through subordination, coverage tests and application of excess spread.

Credit risk is based on several key characteristics specific to TPS CDOs including:

Newly Issued TPS- Newly Issued TPS- Prospectus ComparisonProspectus Comparison

ALESCO: “…the excess interest proceeds that would normally be available for distribution to the preferred shareholders will be applied to the repayment of principal of the notes in sequential order, beginning with the class A-1 and A-2 notes, then the class B-1 and B-2 notes pro-rata, until each class of notes has been paid in full.”

TRAPEZA CDO IV LTD/INC.: “…. the excess interest proceeds that would normally be available for distribution to the membership interest is applied to the repayment of principal of the notes in reverse sequential order, beginning with the class C and D notes, pro-rata, until each class of notes has been paid in full.”

Source: FitchRatings

Banks should diligently review each prospectus. Terms will vary depending on the deal.

Subsidiary Capital Tax Efficient Subsidiary Capital Tax Efficient Securities (SKATES)Securities (SKATES)

• Dividend obligations are noncumulative• Requires minority interest to eventually convert

into more traditional and permanent Tier 1 capital through the conversion into Tier 1 qualified bank-level preferred stocks.

• Perpetual in nature - banking organizations are never forced to redeem these interests in the future.

Definition: An innovative type of capital in the form of preferred stock. Created to transform portions of capital and reserves into minority interests in a consolidated subsidiary of a bank - reducing state taxes based solely on stockholder’s equity.

Real Estate Investment Trust Real Estate Investment Trust (REIT) Preferred Securities(REIT) Preferred Securities

• Tax efficient structure for real estate assets

– Exempt from corporate income tax on distributed earnings

– Must pay 95% of earnings in dividends to qualify for tax break

• Similar to TPS-except investors look to real estate rather than BHC issued sub debt for repayment.

• Essentially secured debt.

FDIC - Proposed GuidanceFDIC - Proposed Guidance

• Providing clarification on the concept of meaningful capital support.

• Confirming the limitations placed upon hybrid capital instruments as a component of regulatory capital.

• Discussing various supervisory and operational aspects of hybrid capital instruments relative to banking institutions and examiners.

The FDIC plans to issue an RD Memo addressing issues arising from the issuance of hybrid capital instruments by FDIC-supervised banks, including:

Guidance Specifics - Guidance Specifics -

• Issuances from a wholly-owned bank subsidiary should meet all of the same terms and conditions that preferred stock issued by the parent bank must meet in order to be includible in Tier 1 capital, as set forth in the FDIC’s capital adequacy guidelines.

• Documentation should clearly state that the hybrid capital instrument is perpetual and cannot be redeemed unless the parent bank receives the prior written consent of the FDIC.

• Issuances out of a wholly-owned subsidiary of the bank should not be included in Tier 1 capital unless it can be converted into, or exchanged for, common or preferred stock of the parent bank upon the triggering of a Conversion Event.

• FDIC reserves the right to exclude from Tier 1 capital any interest, that in its judgment, fails to provide meaningful capital support.

• Terms and conditions of the issuance should be disclosed in public financial statements on a regular basis. Alternative methods should be considered for institutions that do not issue public financial statements.

Conditions for including hybrid capital instruments in Tier 1 capital should be spelled out. Including:

Guidance Specifics (continued)Guidance Specifics (continued)

• The dominant form of a bank’s Tier 1 capital should be voting common equity and banks should avoid undue reliance on hybrid capital instruments.

• Hybrid capital instruments should not constitute more than 25% of Tier 1 capital.

• Hybrid capital instruments in excess of either the individual or aggregate limitations may be included in Tier 2 capital, subject to reasonable limitations.

Capital Limitations will be spelled out. Including:

Guidance Specifics (continued)Guidance Specifics (continued)

• Prior to issuance, banks should undertake a comprehensive assessment of their existing capital structure to ensure that the proceeds are thoroughly incorporated into current financing needs and planning strategies.

• Senior management and the Board of Directors should be actively involved in all aspects of issuance plans to ensure funds are utilized in a reasonable manner consistent with the institution’s risk profile.

• Banks should discuss their plans for issuing hybrid capital instruments with their Regional Office.

Supervisory expectations relating to the issuance and support of hybrid capital instruments will be spelled out. Including: