Over the past two weeks, Trust Preferred (or TruPS) CDOs have gained prominent attention as a result of being the first, and so far only, security that the recently implemented and largely watered-down, Volcker Rule has frowned upon, and leading various regional banks, such as Zions, to liquidate the offending asset while booking substantial losses. But... what are TruPS CDOs, and just how big (or small) of an issue is a potential wholesale liquidation in the market? Courtesy of the Philly Fed we now have the extended answer.
First, some verbal perspectives - highlights ours:
Developed as a way to provide capital markets access to smaller banks, thrifts, insurance companies, and real estate investment trusts (REITs) by pooling the issuance of TruPS into marketable CDOs, the market grew to $60 billion of issuance from its inception in 2000 through its abrupt halt in 2007. As evidenced by rating agency downgrades, current performance, and estimates from our own model, TruPS CDOs are likely to perform poorly. Using data and valuation software from the leading provider of such information, we estimate that large numbers of the subordinated bonds and some senior bonds will be either fully or partially written down, even if no further defaults occur going forward. The primary reason for these losses is that the underlying collateral of TruPS CDOs is small, unrated banks whose primary asset is commercial real estate (CRE). During their years of greatest issuance from 2003 to 2007, the booming real estate market and record low number of bank failures masked the underlying risks that are now manifest. Another reason for the poor performance of bank TruPS CDOs is that smaller banks became a primary investor in the mezzanine tranches of bank TruPS CDOs, something that is also complicating regulators’ resolutions of failed banks.
Then cutting straight to the conclusion:
... the TruPS CDO market provides important insights into how markets respond to regulations; the symbiotic relationship between investment banks and rating agencies in developing models and ratings; how ratings are adjusted over time; and, most recently, how accounting rules have changed with the crisis and have been applied to valuing untraded securities.
The poor performance of TruPS CDOs is first and foremost a direct, and largely unanticipated, result of the financial crisis and the broad-based nature of the real estate downturn. Record low numbers of bank failures over the 2003-2007 period as well as the booming real estate market also help explain the concentrations of issuance volume in these years. The very favorable market conditions combined with good returns relative to other structured finance products also may explain why banks became primary investors in securities in their own market.
Having said this, the very favorable market conditions masked underlying risks. Since bank TruPS CDOs were made up mainly of debt of banks too small to be rated, and since these banks largely invested in commercial real estate (CRE), these deals were, in effect, indirect investments in unrated and deeply subordinated CRE bonds. By comparison, even the riskiest of the synthetic mezzanine subprime CDOs were composed of bonds at least initially rated investment grade.
But having banks both issue TruPS and hold each other’s debt greatly increased those risks, as did the tendency to include the same TruPS issuers in many different CDOs. Banks turned out to be the primary customer for the lower-rated tranches of TruPS CDOs, many of which all models estimate are likely to be fully written down. The rationale for such holdings appeared to be that banks were investing in their own industry, which they ostensibly knew the risks of better than others. While this may not be uncommon for such a niche class of securities, it undoubtedly increased these risks once the downturn commenced. We show that banks’ being the primary investors of the TruPS CDOs in their own industry was publicly reported in the investment banking literature as early as 2004, but none of the major players, dealers or rating agencies, expressed any concerns or made significant model adjustments until after the TruPS CDO market came undone. Since ratings do not take into account the investor base of a deal, nor do rating agencies keep track of who investors are, this would have to fall to the dealers to police. These agents are conflicted when a primary motive is to generate business.
There was a regulatory arbitrage point to these investments as well. Banks that hold each other’s equity are not allowed to count these as capital, but no such restrictions were placed on TruPS CDO investments at banks, which are hybrid debt/equity TruPS. Here the opaqueness of the structure itself and the limited disclosure made it difficult for regulators to actually determine how to account for TruPS CDOs for regulatory accounting purposes. Had banks been required to deduct portions of their TruPS CDO investments from capital, this may have limited bank investments in TruPS CDOs, which, in retrospect, would not have been a bad thing.
Future TruPS CDO issuance was dead long before Dodd-Frank placed restrictions on TruPS as regulatory capital. More important is the highly uncertain future of existing deals. Defaulting BHCs have yet to resolve their TruPS, but this will have to be done at least by their fifth year of deferral, which is the limit to which they can defer without defaulting. Rating agencies are making a conservative assumption that all existing deferrals are leading to defaults with little or no recovery. This has created disagreements among analysts responsible for conducting valuations. More work needs to be done to determine how these deferrals will play out and what assumptions are most reasonable to make regarding recoveries. In the meantime, efforts to resolve defaulted bank TruPS claims could add greater clarity to assumptions on recoveries so critical to loss forecasts.
... what is needed in ABS/MBS markets is objective, critical analysis from analysts and researchers who are not profiting in any way from new issuance. An important aspect of the development of the TruPS CDO market, and of structured finance markets in general, is the dominance of analysis by companies directly profiting from new issuance. This is not unusual, and, in fact, is necessary. Innovation is greatest with economic incentives, and this process should not be hampered by regulation. Having said this, a more critical analysis of these deals may well have uncovered the high-risk nature of these investments that appeared to be captured in the large spreads and exceptional amounts of subordination in the AAA-rated senior classes of TruPS CDOs. More important, as the above-mentioned market concentrations became clearer, rating agency and issuer pricing models should have taken more account of this.
They didn't, and the financial system collapsed. As for "objective, critical anslysis", why who needs that when one has paid-for professors like Craig Pirrong who have made a living of collecting "expert academic" fees simply to sign off on industry memoranda?
Anyway, enough words: here are the promised TruPS CDS charts and figures:
full Philly Fed working paper can be found here.