The diversified trust preferred CDO (DTP CDO), one of the newest CDO products, first appeared in the CDO market in 2000. The collateral, trust preferred securities, has been a favored capital option for larger financial institutions. Since 1996 when the Federal Reserve Board (FRB) approved trust preferred securities as Tier 1 capital, public trust preferred issuance reached $55 billion in total as of June 2002.
While larger banks have benefited from using trust preferreds as a cheaper capital source, smaller regional banks had not, prior to the advent of DTP CDOs. Historically, trust preferred usage differed dramatically across banks. Excluding the trust preferreds issued through DTP CDOs, we estimate that only 2% of smaller banks issued trust preferreds vs. 32% for larger banks (e.g., with more than $5 billion in assets) vs. 60% for the largest banks (e.g., top 50 banks by asset size). The primary reasons smaller institutions have not issued trust preferreds are high transaction costs for issuers and investor perceptions of greater event risk and less liquidity associated with individual small banks. These factors impede small banks' ability to access the capital markets on a stand-alone basis.
DTP CDOs present a "win-win" solution for issuers and investors. By forming a consortium of regional banks to issue DTP CDOs, underlying banks benefit from the economies of scale found when issuing through the CDO, and CDO investors enjoy regional diversification. In essence, DTP CDOs offer small banks a viable way to raise Tier 1 capital.
DTP CDOs have already changed the landscape of the trust preferred market. As of June 15, approximately 450 regional banks issued a total of $5.2 billion trust preferreds through DTP CDOs since the inception of the DTP CDO product in 2000, with another three deals totaling $1.3 billion in the pipeline. This has almost doubled the trust preferred issuer base and increased the market size by about 10%. The advent of the DTP CDO marks a new era where improving capital adequacy via trust preferred issuance is no longer only a game that bigger banks can play; small banks can play it as well. This is a big step towards establishing a more level playing field for all banks.
We estimate at least 16 and as many as 44 DTP CDOs may be done in the future, subject to bank selection criteria and our assumed trust preferred usage rates. We expect DTP CDO issuance to slow down slightly but remain steady. So far the fast pace of DTP CDO issuance coupled with the current stringent eligibility criteria (such as the 10% pro forma Tier 1 requirement) reduces the availability of quality "collateral banks" (which is why issuance should slow).
Under the hood
Perhaps the greatest difficulty in analyzing DTP CDOs is to assess collateral creditworthiness. Collateral banks in DTP CDOs are often too small to be rated by the major rating agencies. Rating agencies have approved two primary approaches to evaluate the collateral credit quality for DTP CDOs. These include obtaining rating estimates for each issuer, or adopting a "pooled approach." For a fee, issuers can obtain estimated ratings for some or all of the individual trust preferreds in DTP CDOs. Since obtaining the estimated ratings can be too costly, most DTP CDO issuers choose to use the "pooled" approach.
The "pooled" approach assumes that collateral banks possess similar credit quality as the overall bank universe; i.e., collateral banks perform at the average of the overall bank universe. The credit quality of an average commercial bank is inferred from historical FDIC bank intervention rates, which indicate about a triple-B rating. We think the FDIC's intervention rates are a conservative measure for bank failure rates for two reasons: 1) All FDIC interventions were counted as defaults, though an intervened bank might continue to operate under some arrangements, enabling it to continue meeting partial or all obligations. 2) The intervention rate is computed on an occurrence basis, and each bank was counted individually; i.e., if one multi-bank holding company experienced five defaulting subsidiaries instead of one, five defaults were counted.
To be eligible for DTP CDOs, collateral banks are often subject to a set of selection criteria. Some typical eligibility criteria for collateral bank inclusion are: asset size greater than $200 million; pro forma Tier 1 capital ratio greater than 10%; and chartered five years and longer. We demonstrated that there is clear evidence that positive selection biases existed based on stratified historic bank intervention rates across bank size, capital ratio and age. If history is a guide, by selecting larger, better capitalized and more established banks, we are likely to see fewer bank failures.
We believe banks possess sound bank fundamentals, highly detailed disclosure, rigorous regulatory oversight, and better risk management, all of which have resulted in increased public confidence in banks. Smaller regional banks not only share those positive attributes, but also focus mainly on consumer finance and have far lower exposure to large corporations, which have been the main source of recent negative headlines. Regulators remain strong proponents of industry consolidation, which reduces competition, improves efficiency and enhances profit margins. We think small banks are well positioned in the event of consolidations and can benefit from acquirers' larger and higher credit quality franchises.
Key ingredients for structuring
Having gained some insight into the collateral fundamentals, we turn our focus to collateral portfolio risk and CDO structural enhancements.
There is clear evidence of regional differences within the banking sector. For example, regional bank failures did not peak at the same time, and were more largely concentrated in the Southwest. We also implemented a quantitative diversification framework to assess the "diversity score" of DTP CDO pools. We believe local economics and regional legislative differences are key drivers of regional diversification. By selecting banks from various locations, regional diversity is introduced to DTP CDOs, resulting in a better risk/return profile.
It is difficult to make any meaningful assessment of the recovery value, interest deferral frequency, and prepayment likelihood of trust preferreds. This is partly because of the short history of the bank trust preferred market and the healthy banking environment since the inception of the trust preferred market in 1996. While we think Fitch Ratings' 10% recovery rate assumption on trust preferreds is reasonable, two things point to the "conservatism." These include the aforementioned adoption of a broad bank failure definition and the greater historical recovery rate of preferred stock. Preferred stock, while typically junior to trust preferreds, recovered an average of 15% in the past (1970-2001).
Another unique aspect of trust preferreds is that they are allowed to defer interest, typically for five years. Interest deferral does not usually affect PIKable mezzanine or junior CDO notes as much as non-PIKable senior CDO notes, as timely payment of interest is not a must for mezzanine or junior CDO notes. Nonetheless, interest deferral may affect senior noteholders' ability to receive timely cash flows. A typical mitigant is to establish a liquidity facility at the outset and/or to fill it over time with available excess spread.
Should collateral be called, static pool CDOs de-lever, likely resulting in higher enhancement to CDO debt. This is likely a positive credit event for CDO debt, assuming no adverse selection in the collateral pool. On the flip side, it shortens the average life, likely resulting in lower total returns.
DTP CDOs do have a long legal final (typically 30 years), and may have a longer average life if the collateral call rate is slow. Two common structural enhancement features seen in long maturity CDOs including DTP CDOs are "debt turboing" and "an auction call," both of which are intended to reduce the average life of CDO debt.
In our view, regional banks' fundamentals remain sound, as they continue to maintain sufficient margin, manageable asset quality and ample capital, all of which contribute to a low failure rate. We believe well-capitalized regional banks that have focused management teams, robust customer bases and strong deposit franchises will perform as strong credits, enhancing DTP CDOs' performance.
We believe the primary risk factors associated with investing in DTP CDOs are uncertainties related to long-term bank credit quality, adverse collateral selection issues, the lack of diversification beyond the banking sector, longer average lives and the short history of DTP CDO performance records.
Should regional banks continue to sustain a low failure rate, we believe DTP CDOs not only provide a cost-efficient capital solution for small banks, but also are likely to deliver strong returns for CDO investors, a "win-win" for market participants. DTP CDOs also offer long-term investors seeking exposure to the banking sector's attractive relative value opportunities, as DTP CDO notes offer a substantial spread pickup over other more established products such as HY CDOs, with greater credit enhancement and better collateral credit quality. For example, DTP CDO triple-As priced in the range of L+70-100 basis points, 20-50 basis points wider than other cash flow CDOs; while single-As priced in the range of L+205-220 basis points, at least 40 points wider. DTP CDOs also offer greater credit enhancement to triple-As vs. HY CDO triple-As, with better collateral credit quality. We think some of the spread pickup is due to the longer legal final and longer average lives, but most of it is attributable to a "novelty premium" that will likely disappear as the product gains more investor acceptance, a good track record and improved liquidity.
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