Bloomberg News

Volcker Stoking Rally in TruPS as Buyers Circle: Credit Markets

January 09, 2014

A new rule forcing banks to sell a type of complex debt security created before the financial crisis is having a surprising effect: luring buyers to the market and driving up the prices of those bonds.

Portions of collateralized debt obligations that are backed by trust-preferred securities issued by banks, known as TruPS CDOs, have more than doubled the past year to almost 40 cents on the dollar in some cases, according to prices from JPMorgan Chase & Co. One lender that planned to write down its holdings to almost zero is now seeking as much as 25 cents on the dollar, according to Mike Manning, co-founder of DealVector Inc., which runs an electronic system that connects buyers and sellers of the debt.

Hedge funds from Anchorage Capital Group LLC to Third Point LLC are seeking to snap up securities in the $41.2 billion market after prices started climbing last year as banks bolstered their balance sheets in an improving economy. They’re circling as lenders from Salt Lake City’s Zions Bancorporation to New Jersey’s Cape Bancorp Inc. say they must sell because of regulation provisions now being reconsidered that restrict such holdings by banks.

Pain Moderated

“The pain wasn’t as bad as we thought it would be,” said Michael Devlin, chief executive officer of Cape Bancorp, which sold all of its $8.3 million of TruPS holdings last month at a loss of about $850,000, compared with its previously estimated write-off of $2.5 million at the end of September. “We would have sold even at $2.5 million, just to resolve the issue.”

Third Point is looking to join Hildene Capital Management LLC and other hedge funds including Och-Ziff Capital Management Group LLC and Eton Park Capital Management that bought TruPS after their prices plunged amid the worst financial crisis since the Great Depression, according to three people with direct knowledge of the matter, who asked not to be identified because the trades are private.

Anchorage, which has been buying the debt since 2010, is considering adding more, one of the people said.

Some of the lowest-ranked securities were trading for between 30 and 40 cents on the dollar this month, up from prices in the “single digits to teens” a year earlier, JPMorgan said in an e-mail to market participants.

Zions’s Reaction

The PowerShares Financial Preferred Portfolio (PGF:US), an exchange-traded fund (PGF:US) that tracks preferred securities issued by banks and insurance companies, has climbed 2.3 percent the past two weeks to $17.24 after initially dropping to as low as $16.81 in the days following completion of the regulation known as the Volcker Rule. The ETF plunged to as low as $5.16 at the height of the crisis in 2009.

After regulators approved the final version of the rule named for former Federal Reserve chairman Paul Volcker in the Dodd-Frank Act on Dec. 10, Zions said the ban would force it to dispose of its holdings at a cost of about $387 million, more than the bank earned for any calendar year since 2007. Utah’s biggest lender is determining how and when to sell, and won’t “just go out and dump those things tomorrow,” Chief Financial Officer Doyle Arnold said in a Dec. 16 conference call.

While banks were given until July 2015 to comply with the rule, the American Bankers Association, which represents mostly community banks, sued last month to block the rule, saying small lenders will suffer about $600 million in losses.

‘Out of Woodwork’

U.S. financial regulators are considering giving them grandfathering protection or other means to hold onto the securities, Bloomberg News reported yesterday, citing two people with knowledge of the discussions. They want to grant a narrow exemption to limit lenders’ ability to apply it to other restricted funds, said the people, who requested anonymity because the talks are private.

Investors “got all worried, but when they do that, everyone comes out of the woodwork,” said Brett Jefferson, chief investment officer at Hildene Capital Management LLC, which holds $2.5 billion of TruPS CDOs. “Because of that, people are now doing the work on these and saying, ‘OK, I see the value that’s there.’ There are a lot of big brand-name people coming in to look at this product.”

Best Decision

While it’s possible lenders who sold their TruPS CDOs may regret acting too quickly should regulators in the end allow them to keep the debt, they likely made the best decision they could at the time, said John Kanas, chief executive officer of Miami Lakes, Florida-based lender BankUnited Inc.

“It’s dangerous to presume how regulators are going to act,” Kanas said in an interview today in New York. While BankUnited does not own TruPS CDOs, Kanas sold the bank’s $431 million portfolio of similar securities that are tied to loans to speculative-grade companies after they were banned under the final Volcker Rule, he said.

TruPS, created in the 1980s and considered a hybrid of common stock and debt, were a staple for financial institutions before the market seizure that started in 2007 because they counted toward meeting regulatory capital requirements. Interest on the securities is paid from pre-tax income and can be suspended without penalty, which lenders did amid the crisis to preserve capital, fueling the plunge in TruPS prices.

Market Shrinking

As Wall Street bankers started bundling the securities into CDOs in 2000 and marketing portions ranked as high as AAA, it allowed banks of all sizes to invest in TruPS, leading to an explosion in issuance.

After reaching $60 billion before its halt in 2007, the market shrunk to $41.2 billion at the end of 2013, according to Federal Reserve Bank of Philadelphia research. That compares with the more than $800 billion of outstanding U.S. home-loan bonds without government backing, according to Fed data.

About 3 percent of U.S. banks held the securities as of Sept. 30, according to analysts at Sterne Agee & Leach Inc. Zions was the biggest holder among its peers as a percentage of total capital, with $1.2 billion, the analysts said. Wells Fargo & Co. and Citigroup Inc. are among the top five holders by dollar amount, the data show.

“Since a number of banks are holders as well as issuers of TruPS, a rally in CDOs could have a knock-on benefit of enhancing their capital positions depending on whether they have been aggressive or conservative” in valuing the holdings, DealVector’s Manning said. “We have seen both.”

‘Reasonable’ Value

Along with Cape Bancorp in Cape May Court House, New Jersey, Community Bank System Inc. of DeWitt, New York, also rushed to sell holdings of the securities when the Volcker Rule was completed. Community Bank liquidated its entire portfolio of bank and insurance TruPS CDOs at a loss of $15.5 million, it said in a Dec. 31 statement.

“We got a reasonable fair value for these things,” Scott Kingsley, Community Bank’s chief financial officer, said in a telephone interview.

“This wasn’t even on our radar screen,” Devlin said. “When we got the inkling in early December, I was dumbfounded that we were going to be pulled in on this. My idea was the regulators didn’t fully fathom the implications.”

Regulators won’t be able to ignore the pressure from industry groups, Jaret Seiberg, a financial services policy analyst at Guggenheim Securities LLC’s Washington Research Group, wrote in a Dec. 17 research note.

Drawn by Supply

The biggest gains in prices since the Volcker Rule’s approval were in lower-ranked portions, of which “the small, medium-size U.S. banks own more” than senior debt, Adam Mandel, a principal and fixed-income trader at Sandler O’Neill & Partners LP said in a telephone interview.

“That was really the stuff they had on their books that they’re being faced with potentially having to sell,” he said. In the senior portions, “folks saw some weakness in the market because they were a little worried” that the selling by banks would outweigh demand for that debt, he said. Those bonds fell by more than 5 cents on the dollar after the rule was announced, he said.

Anchorage, Third Point, Eton Park and Och-Ziff declined to comment through their representatives.

Investors are being drawn not by lower prices, “but just because there’s going to be potentially supply,” Mandel said. “We’ve spent a fair amount of time with folks who have not been invested in the market, and they’re getting smart, because there’s a fair amount of paper potentially coming out.”

Credit Benchmarks

Elsewhere in credit markets, the cost to protect corporate bonds from default in the U.S. reached a three-week high. Diaverum AB, the dialysis-clinic operator owned by Bridgepoint, is planning to raise about 900 million euros ($1.2 billion) of debt to help refinance loans and build its business.

The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, increased 0.4 basis point to a mid-price of 65.4 basis points as of 11:17 a.m. in New York, according to prices compiled by Bloomberg. The index is trading at the highest since Dec. 19 after reaching a six-year low of 62 basis points on Dec. 26.

In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings added 1.1 to 71.2.

The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

GE Offering

The U.S. two-year interest-rate swap spread, a measure of debt-market stress, rose 0.38 basis point to 11.88 basis points, heading for the highest close since Nov. 7. The gauge typically widens when investors seek the perceived safety of government securities and narrows as they favor assets such as corporate debt.

Bonds of Fairfield, Connecticut-based General Electric Co. (GE:US) are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 4.1 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The company, with the most debt maturing in 2014 of any U.S. corporate issuer, sold $3 billion of bonds yesterday in a three-part offering through its GE Capital unit. Its $1 billion of 2.3 percent notes due January 2019 climbed 0.2 cent from the issue price to 100.05 cents on the dollar, yielding 2.29 percent as of 11:12 a.m. in New York, Trace prices show.

Diaverum is considering replacing about 700 million euros of borrowing and getting a further 200 million euros to help expand, according to a person familiar with the matter, who asked not to be identified because it is private. The Lund, Sweden-based company is considering issuing bonds as well as loans in Europe and the U.S.

Bridgepoint acquired Diaverum from Gambro Holding AB in July 2007 using 5.15 billion kronor ($785 million) of debt that starts to mature this year, according to data compiled by Bloomberg.

To contact the reporters on this story: Mary Childs in New York at mchilds5@bloomberg.net; Elizabeth Dexheimer in New York at edexheimer@bloomberg.net

To contact the editors responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net; Peter Eichenbaum at peichenbaum@bloomberg.net


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Companies Mentioned

  • PGF
    (PowerShares Financial Preferred Portfolio)
    • $18.12 USD
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  • GE
    (General Electric Co)
    • $25.79 USD
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