Algorithmics’ latest white paper analyzes the options for CDO investors in trust preferred securities (TruPS) in light of the current market debate about whether investors should take up discounted redemption offers or continue to hold for a potentially greater cashflow in future.
Approximately $50 billion of TruPS issued by US banks and insurance companies have been pooled and repackaged into collateralized debt obligations (CDOs) since 2000. The original intent of securitizing TruPS collateral into a CDO structure was to achieve economies of scale and access to the capital markets for smaller issuers such as small community banks.
While the passage of the financial reform act in July 2010 (the Dodd–Frank Wall Street Reform and Consumer Protection Act) eliminates trust preferred securities as an element of Tier 1 capital after an 18-month transition period, it exempts banks with less than $15 billion in assets, which encompasses much of the universe of banks that are issuers in TruPS CDOs.
So while many larger banks will need to recapitalize, smaller community banks are exempted from this provision. The net effect will be that TruPS CDOs, and all of their complicated valuation and redemption issues, will still be around for quite some time. Not every situation will be the same, and will require analysis on a case-by-case basis.
Richard Hrvatin, managing director, Credit Advisory, Algorithmics, commented: “There are approximately $20 billion of performing TruPS still eligible for ongoing Tier 1 capital treatment under the Collins Amendment to the Dodd– Frank Act. From the CDO investor’s perspective, since cashflow from a deferring issuer may be currently non-existent, would it be better to have a certain payment today (meaning the discounted redemption offer), or is it better to ‘wait it out’ for an uncertain, yet potentially greater, cashflow in the future? From our research, the short answer is ‘it depends’ – mostly on the probability that the TruPS may default. If that is low then riding out the storm could be the best alternative.”
Algorithmics conducted a series of simulations and sensitivity tests on a hypothetical CDO structure. Using a mark-to-model approach, cashflows to the CDO were analyzed under a variety of scenarios and discounted at the respective note’s coupon rate to determine a present value for each class of CDO investor. Inputs that were varied included: credit quality and subsequent default probability of the TruPS issuer; number of issuers currently in deferral or defaulted; leverage and structural features in the CDO; and correlation amongst the TruPS issuers in the portfolio.
Key findings include:
The fair discount offer for a TruPS is directly proportional to the bank’s survival probability.
The valuation of the senior class holds up regardless of the stress scenario, but their average life is shortened. Taking out the senior class sooner allows future excess spread to flow to the mezzanine class. Therefore, the pricing impact mostly affects the mezzanine class of CDO investors.
Depending on the default probability of the TruPS issuer, riding out the storm is the better alternative because of the potential for future excess spread.
To download a copy of Algorithmics’ latest white paper, ‘The Effect of Redemptions on Bank Trust Preferred Securities’, visit: http://www.algorithmics.com/EN/media/pdfs/Algo-WP0910-TruPS.pdf
