What were Trust Preferred Securities (TruPS)?

Large banks and bank holding companies (BHCs) issued hybrid securities known as trust preferred securities (TruPS), which were part of regulatory Tier 1 capital and whose dividend payments were tax deductible for the issuer.

The bank would establish a debt-funded trust, dividing its shares and providing preferred stock to investors. The resultant shares were referred to as TruPSs, or trust preferred securities.

Since its first release in 1996, TruPS has been under closer regulatory scrutiny, especially after the 2008–2009 financial crisis. Most of them were phased out at the end of 2015 due to the Volcker Rule and the Dodd-Frank regulations.

Understanding Trust Preferred Securities (TruPS)

Both stock and debt features apply to the trust’s preferred security. Despite being financed by debt, the trust’s issued shares are regarded as preferred stock and entitled to dividends like preferred stock. The payments made to the investors are considered interest payments by the IRS and are held in trust as the funding vehicle for the bank’s debt.

Because the debt used to establish the trust has a lengthy maturity schedule, the trust’s preferred asset often delivers a more outstanding monthly payment than a share of preferred stock. It may have a maturity of up to 30 years. There are two possible payout schedules for stockholders: variable and fixed. Furthermore, there are features in trust-preferred securities that permit interest payments to be postponed for a maximum of five years. After the period, the TruPS matures at face value, although the issuer may choose to redeem it earlier.

Companies have produced trust-preferred securities because of their flexible nature and advantageous accounting treatment. In particular, these securities are subject to Internal Revenue Service taxation similar to debt obligations while continuing to appear as stocks in a company’s financial statements by GAAP. The issuing bank makes tax-deductible interest payments into the trust and then disburses them to its shareholders.

It is crucial to understand that an investor purchasing a trust-preferred instrument is not purchasing a stake in the bank itself but instead purchasing a share of the trust and its underlying assets.

Particular Points to Remember

A provision of the 2010 Dodd-Frank financial reform legislation said that trust-preferred securities issued by institutions with assets exceeding $15 billion would no longer be eligible for Tier 1 capital classification by 2013. Under Tier 1 capital treatment, the amount of money banks have invested in their trust preferred securities may be used against their Tier 1 capital ratio—the amount of money they have set aside to cover losses from bad debt.

The Tier 1 capital ratio’s phase-out or exclusion of trust-preferred securities raises banks’ financing needs and, in some situations, lessens their incentives to issue trust-preferred securities. A proposal known as the “Collins Amendment” was made in the US Senate to exclude trust-preferred securities from Tier 1 regulatory capital completely.

Lastly, since trusts can offer characteristics like early share redemption and interest payment postponement, the expense is one of the drawbacks for businesses issuing trust-preferred securities. Because of these subtleties, investors find them less appealing. As a result, trust-preferred securities often have higher rates than other forms of debt because they expect a higher rate of return. Moreover, significant investment banking fees may be associated with underwriting the securities.

Conclusion

• Trust preference securities were a particular kind of bank-issued asset that combined equity and debt.
• Due to legal and regulatory actions taken in the wake of the 2008–2009 financial crisis, they have been mostly phased out.
• By way of debt issuance, banks or bank holding companies issue TruPS, which are preferred trust stock shares.
• With a maturity of up to thirty years, the trust’s preferred security often gives a more significant monthly payment than its preferred stock.
• The cost of TruPS is a drawback for the issuer since investors want more significant returns on investments that include features like early redemption or interest payment deferment.