The Rise and Fall of Trust Preferred Securities (TruPS): Hybrid Investment Unveiled
Trust preferred securities (TruPS) were innovative hybrid securities issued by large banks and bank holding companies (BHCs). Not only were they included in regulatory tier 1 capital, but the dividend payments made on them were also tax-deductible for the issuer.
The structure involved banks creating a trust that was funded with debt. They then divided shares of this trust and sold them to investors in the form of preferred stock. These became known as Trust Preferred Securities, or TruPS. First introduced in 1996, they faced heightened regulatory scrutiny after the calamitous financial crisis of 2008–09 and were mostly phased out by the end of 2015 due to legal and regulatory reforms, including the Dodd-Frank Act and the Volcker Rule.
Key Takeaways
- Trust preferred securities combined elements of both debt and stock, making them a unique financial instrument.
- They were commonly issued by banks or bank holding companies but were largely phased out following the regulatory actions taken after the financial crisis of 2008-09.
- TruPS had relatively high periodic payments compared to traditional preferred stock and could mature in as long as 30 years.
- Some of the disadvantages for issuers included higher costs, as investors often demanded greater returns to compensate for features such as the potential deferral of interest payments or early redemption clauses.
Understanding Trust Preferred Securities (TruPS)
TruPS stood out due to their dual characteristics: elements of both debt and preferred stock. While the underlying trust was funded by debt, the issued shares were treated as preferred stock and still paid dividends akin to traditional preferred shares. However, in practice, investors received interest payments, which the IRS taxed accordingly.
TruPS notably offered higher periodic payments in comparison to traditional preferred stock, attributable to the extended maturity timeline of the underlying debt. The payments might follow a fixed or variable schedule, subject to the specific terms of the issuance. Some contained provisions permitting the deferral of interest payments for up to five years. When TruPS matured, they did so at face value, though issuers had the option for early redemption.
These securities gained popularity for their favorable accounting and tax treatments. They are treated as debt for tax purposes, but appear as equity in the company’s financial statements according to GAAP procedures. Importantly, when investors purchased TruPS, they acquired part of the trust with its underlying debt, not direct ownership in the bank.
Special Considerations
The Dodd-Frank Act, passed in 2010, included measures to phase out the inclusion of trust preferred securities in the Tier 1 capital treatment for institutions with assets over $15 billion by 2013. Excluding TruPS from Tier 1 capital ratios increased funding requirements for banks, and consequently, reduced incentives for banks to issue these types of securities. This included provisions such as the “Collins Amendment,” which aimed to eliminate TruPS as part of Tier 1 regulatory capital.
The cost aspect also posed challenges for companies issuing TruPS. The issuances often had provisions for deferral of interest payments and early redemptions, making them less appealing to investors, and typically leading to higher demanded rates of return compared to other debt forms. Moreover, the underwriting fees involved could be considerable.
Related Terms: preferred stock, Tier 1 capital, debt obligations, Dodd-Frank, economic reform, Volcker Rule, bank holding companies.
