Fitch Ratings stated that as of July 20 defaults on U.S. bank Trust Preferred Security (TruPS) CDOs eclipsed the 14% mark on 11 new bank defaults.
The new defaults totaled $129.5 million, which affected 16 CDOs. Additionally, 22 banks began deferring interest payments on roughly $302.5 million of collateral in 23 TruPS CDOs.
The 11 new bank defaults bring the total to 134, impacting 82 CDOs. The 357 banks are now affecting interest payments on $6.5 billion of collateral held by 83 TruPS CDOs.
"All defaults that took place this past month were among previously deferring banks," said Johann Juan, director in structured credit at Fitch. "The escalated rate of defaults in July did stem bank deferrals slightly."
Although deferring banks are more likely than non-deferring banks to default, certain well-capitalized banks have also elected to defer. According to a report published by PF2 Securities Evaluations, well-positioned banks are also taking this route.
"On examining all banks in these TruPS CDOs to begin deferring distributions in either 2008 or 2009, we noticed a mild pattern that suggests an increased tendency in 2009 for good banks to elect to defer, while fewer of the deferring banks were strictly troubled, particularly in the second half of 2009," PF2 analysts said.
According to PF2, based on Federal Deposit Insurance Corp. (FDIC) statistics of 8,012 FDIC-insured financial institutions as of December 31, 2009, a roughly 2.24% annualized default rate was anticipated as of June 18.
This default rate constitutes a 46% increase over the September 30, 2009, annualized default rate of approximately 1.53%, which was based off the December 31, 2008, statistics of 8,305 FDIC-insured financial institutions.
"Having realized this 46% increase, and from our various conversations with market participants and regulators, our best guess estimate is to anticipate another weighted average increase of 35%, over the forthcoming two-year period," PF2 analysts said. "Thus, over the coming period, we attach an expected default probability of 3.02% to the average performing bank in our analysis of TruPS CDOs."
The Dodd-Frank Wall Street Reform and Consumer Protection Act, which President Obama signed into law on July 21, offers banks a loophole in the form of a three-month window to redeem their TruPS at face value. If banks redeem their TruPS,TruPS CDOs could potentially benefit from the reduction of default risk in their collateral portfolios. Banks have the contractual right to redeem these securities through October 2010.
Moody's Investors Service analysts said that the window affects 7% of TruPS CDO collateral that the agency rates. The extent to which the window applies to a particular CDO will depend on its collateral portfolio composition.
"TheseTruPS CDOs have exposure to 32 of the 50 top bank holding companies that the Federal Reserve lists as having assets greater than $15 billion as of June 30," Moody's analysts said.
The transaction can opt to apply the redemption proceeds, which equal the TruPS' face value, to amortize the TruPS CDO notes according to the priority of payments stated in the indenture.
"In the absence of redemptions, default risk would climb," Moody's analysts said. "In the past three years, bank failures have occurred at record levels. More bank failures mean more TruPS defaults for TruPS CDOs, resulting in higher losses to TruPS CDO noteholders."
Redemption of TruPS held in a TruPS CDO portfolio removes the TruPS from the portfolio and thereby eliminates their potential default risk to the TruPS CDO, analysts said.
Banks have yet to utilize the redemption provision, and it's unlikely that many will use this option unless individual circumstances and the capital markets provide an advantageous opportunity.
The decision, Moody's analysts said, depends on a bank's ability to reduce its cost of capital by repaying these securities and the receptiveness of capital markets for issuing replacement capital.
"Any optional redemption at par by high-risk obligors is a positive for TruPS CDO senior notes, but it is unlikely that these obligors will redeem their TruPS given their current financial condition," said Derek Miller, a senior director at Fitch.
To be sure, the forecast for the sector remains strained by the continued deterioration within the sector. Defaults and deferrals have been gradually rising over the last several months, most notably among bank TruPS CDOs, noted Fitch analysts.
Even the option of redemption presents a potential increase in risk for TruPS CDOs if they aren't matched by a capital issuance of significant size. The credit implications for banks redeeming TruPS depend on how the redemption is financed. Banks that opt to redeem all or a portion of their TruPS during the 90-day window might have to raise some form of replacement capital, in the same way that banks replaced capital when they redeemed preferred stock issued under the Troubled Asset Relief Program (TARP) Capital Purchase Program.
According to Moody's, these banks that repurchased TARP preferred stock raised as much as half of the funds in common equity. It's likely that common equity would have to also serve as substitute for TruPS, if repurchased during this 90-day window. This would lead to a higher-quality capital base, but without it the opposite effect would occur.
"Redemptions can also reduce the liquidity resources of a company," Moody's analysts said. "We would be surprised if many banks redeemed their TruPS without replacing capital given the regulatory focus on capital and the absence of clear capital guidelines, as well as the uncertain economic environment."
