Banks and insurance companies that issue trust preferred securities are now highly sensitive to financial institution risk and have acquired a distaste for the CDO structure, which has pooled these securities.
As a result, issuance in U.S. Trust Preferred Security (TruPS) CDOs has ground to a halt, and the prospects for future issuance are not too encouraging.
"That market is just crushed; nobody is touching that stuff," a CDO market participant said.
Indeed they are not. TruPS CDO issuance has been nonexistent in 2008, and Moody's Investors Service said it has rated only five deals since the summer turmoil began in July 2007. These deals comprised either bank TruPS or a combination of bank and insurance TruPS, with no exposure to REIT securities.
REIT TruPS were previously used in the collateral mix of these deals, though CDOs backed by REITs were almost exclusively backed by them, a Moody's report noted. The outlook for REIT TruPS CDOs is negative as a result of stress in the homebuilder and mortgage REIT markets. Currently, eleven transactions are on review for downgrade by Moody's, and issuance in these transactions is not likely to come back, said James Brennan, vice president and senior analyst at Moody's.
Overhang Clogs Pipeline
Part of what's stopping issuance in the TruPS CDO space has been the overhang of TruPS tranches in the secondary market, Brennan said. "Until that gets worked off, it is going to be hard for new deals to actually come to the marketplace."
But these tranches might take a while to work their way through the secondary market. After July 2007, spreads doubled from approximately 150 basis points to 300 basis points, Moody's said. Triple-B credits are currently trading at 450 basis points over, said a banker at a mid-sized investment bank. "The TruPS CDO market is dead as a doornail. There is no interest in new issuance in this sector, and there won't be as long as the market remains nervous about bank liquidity issues."
Furthermore, a number of these banks that were issuing trust preferred securities were using the proceeds to acquire other banks. As soon as those spreads increased, some of the banks began to rethink their strategies, Brennan said. "There is a hesitation to go back into the market once you have seen that dramatic of a spread difference."
Although most banks and insurance issuers in TruPS CDOs have minimal exposure to subprime residential mortgages, slowing economic conditions in the U.S. and the threat of a possible recession are expected to increase the number of bank and insurance deferrals (of payment). While structural features in these deals might allow the ratings of the tranches to remain stable throughout 2008, despite deferrals in the underlying credits, Brennan said, "if the downturn persists through 2009, the ratings of the CDO tranches could be impacted." However, payment deferrals do have the ability to correct themselves, or "cure," Moody's said, especially on the bank TruPS side. On the other hand, the Moody's report said, there are no very observable recoveries on REIT TruPS CDOs. When these deals miss a payment, they automatically go into default.
While Brennan expected to see issuance in the bank and insurance sectors to return, TruPS CDO asset pools are more likely to be in the $300 million to $400 million range, as many investors have exited the sector. SIVs, which were large buyers of senior TruPS CDO notes prior to mid-2007, according to Moody's, are currently winding down.
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