Weak economic conditions have put capital strains on trust preferred securities (TruPS) issuers, causing a rise in payment deferrals and defaults within pools of these assets, TruPS CDOs.

Despite the government's promise of liquidity via the Troubled Asset Relief Program (TARP), market participants are not convinced that helping the banks will be enough to offset losses in these pools.

The $125 billion left in the $250 billion TARP capital purchase program- after a capital infusion into the nine major banks - will go to some of the banks in these CDOs, which could have a positive impact on the ratings of these deals, said James Brennan, vice president and senior credit officer at Moody's Investors Service.

However, it has become increasingly clear that the money will only be going to healthy banks or financial institutions, meaning troubled banks will likely not have access to that $125 billion.

"There will be banks in these portfolios that will gain access to the TARP plan, which is absolutely a good thing, but we don't think it is going to be enough to offset the other banks that will not be allowed access to the funding," Brennan said.

Indeed, the TruPS CDO market is a roughly $55 billion market, of which 70% are bank TruPS, Brennan said. The basket for insurance TruPS comprises maybe up to a 35% basket in hybrid TruPS CDOs, he said. Hybrid deals are typically a mix of bank and insurance TruPS.

Furthermore, a lot of smaller banks have not been awarded capital yet, and that is where the problem lies, said a banker at a regional investment bank. "If these banks are not able to access the TARP money, their capital bases are going to be severely impacted and they will have to defer payments," he said.

In many smaller banks, TruPS are the instrument of choice for capital because the bank can take the interest payment as a tax deduction, and count it as capital up to 25% of its total capitalization. "Investors are not going to buy TruPS if they get burned by deferred payments," the banker said.

Defaults and Deferrals

As of Sept. 10, 78 of 85 Fitch Ratings-rated bank TruPS CDOs had experienced at least one underlying asset default or on-going deferral, with exposure averaging 5.5% of the current portfolio balance and ranging from a maximum of 18% to a minimum of 0.6%.

Last week, Moody's downgraded 180 tranches across 44 Trust Preferred CDOs. In addition, 88 tranches remain on review for further possible downgrade. The rating agency left a few tranches on further review for a downgrade because there was concern that these securities, which were rated 'Baa3' and higher, could hit an event of default.

The capital injections will allow the banks to operate better by giving them some cushion to absorb the losses.

But TARP's impact on bank TruPS CDO performance could depend on whether or not it has an influence on deferral activity. If the result of carrying additional liabilities in the capital structure is that the more junior debt is deferred, that would impact performance, like any other deferral activity, in the transactions that Fitch looks at, said Fabrice Toka, a senior director in the rating agency's structured credit group. As the injection of capital helps stabilize banks' performance, that will also be reflected in CDO performance.

But the increasingly active stance by U.S. bank and thrift regulators has accelerated the rate at which banks are electing to defer on their TruPS obligations, Fitch said in a report.

And, whether or not a bank applies for TARP money, in this environment, there is still a potential that banks may defer their TruPS payments in order to shore up their capital base, said Beth Nugent, a senior director in Fitch's structured credit group.

Indeed, banks and thrifts that issue these trust preferred securities are facing significant credit pressure from large degrees of exposure to residential construction loans and home equity loans. High growth rates from above-average levels of TruPS issuance and/or brokered deposits have also put pressure on profits, Fitch said. The rating agency said that, as of Sept. 10, it had witnessed $1.7 billion of TruPS defaults, deferrals and credit risk sales across 38 banks.

Though TARP is expected to bring some stability back to the financial markets, it might not be enough to spur new issuance, which has been non-existent since First Tennessee issued a series of trust preferred securities last November.

Part of the reason why the market hasn't seen transactions is because investors are waiting to see what the true bank default rate is going to be. Also, there are a number of banks that were issuing into these trust preferred deals at very low spreads, and spreads have substantially widened.

"I think the issue is banks are saying maybe if I wait a year or two spreads will come in drastically," Moody's Brennan said.

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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