Publications & Resources

February/March 2007
Focus: Balance Sheet Management

Trust Preferred Securities: A Lower Cost of Capital for Community Banks

By Ryan Kelly

The robust domestic economy of recent years has also ushered in an era of high growth and strong profitability among community banks in the Western United States and elsewhere. One principal challenge of the growth is that of maintaining adequate capital while also minimizing the bank’s blended cost of capital. A traditional method of raising Tier 1 Capital is through the issuance of additional common stock. This option is well-accepted, but the process can be costly, difficult, and time-consuming for management and shareholders. More importantly, the issuance of common stock represents the most expensive form of capital. It is dilutive to existing shareholders, which is generally manifested through lower a ROE, unless the bank can leverage the new capital into above-average earnings.

Many bank executives understand the high cost of equity capital, and have found Trust Preferred Securities (“TRUPS”) to be effective in managing balance sheet growth. These securities, issued through a special business trust set up by the bank or thrift holding company, can comprise up to 25% of the bank’s total Tier 1 Capital, and act as a critical piece of a bank’s capital structure from a cost of capital perspective. TRUPS feature a unique blend of both equity and debt-like characteristics. They are afforded Tier 1 Capital treatment due to their long-term nature, five-year no call provision, and absence of restrictive covenants or change of control provisions. On the other hand, their interest-only quarterly dividend payments are tax deductible similar to bond coupons. Uses of proceeds from the issuance of TRUPS are flexible, and can be used to fund acquisitions, refinance high-rate debt, support core growth, and repurchase stock. Finally, while regulatory approval from the Fed is required for issuance of TRUPS, these securities will not add any significant additional regulatory burden to the bank.

The benefits of TRUPS have been recognized by community banks as seen through the growth of the market. Since the Fed approved Tier 1 Capital treatment for these securities in 1996, the market has exploded. By 2000, pools of Collateralized Debt Obligations (CDOs) for TRUPS emerged, and by late 2003 large warehouse lines appeared. The pooled bank Trust Preferred market in the U.S. exceeded $7.5 billion in 2006 alone.

The current funding process into the TRUPS pools is significantly less expensive and more flexible than it has been in the past for issuers of all sizes. A $70 million holding company is essentially as likely to issue Trust Preferred as a much larger institution. Coupon types are now available on a fixed or floating rate basis. Moreover, in some instances, banks can lock rates up to three months in advance. Discount fees have gone from 3% to 0%. Legal and trustee fees were once paid by the issuer, and are now paid by the original purchaser of the TRUPS. Because of the emergence of warehouse lines, funding can now occur whenever an issuer desires. This stands in sharp contrast to the past in which the timing of funding always coincided with the closing of the CDO.

Ultimately, the most important catalyst of growth in the Trust Preferred market is pricing. In the early days of the market, pricing to issuers was predominantly floating rate at 3-month LIBOR plus 350 basis points. That spread was sometimes even wider depending upon credit assessment. Today the spreads for Trust Preferred have come down dramatically, and are now generally in the 165-195 basis point range. This has profound ramifications for a bank’s overall blended cost of capital as illustrated below.

The market will continue to see high volumes of TRUPS in 2007 and beyond. Many bank holding companies which issued these securities as early as 2002, are now moving past the five-year no-call window. For these issuers, pricing spreads over 3-month LIBOR on their Trust Preferred should see significant reductions from approximately 350 basis points of a few years ago down to the lower range of today’s market. Although new supply could conceivably move spreads moderately higher, this still remains a compelling time to issue or re-finance Trust Preferred Securities. Even banks who do not anticipate requiring additional capital in the short-term, might consider issuance while spreads remain low. As these banks continue to grow their balance sheets over time, Trust Preferred can act as a key capital component to support that growth.

Ryan Kelly is a vice president in the Zions Bank Correspondent Banking Group in Salt Lake City . He can be reached at ryan.kelly@zionsbank.com or (801) 844-7870.

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