NEW YORK (
) -- The former sharks of Wall Street are turning into guppies while conservative lenders like
(WFC - Get Report)
(JPM - Get Report)
may be taking the the reins as the next generation of risk takers in the financial sector.
That's because once conservative banks are issuing paper - called perpetual preferred securities -- that will allow them to grow their balance sheets in coming years, while the titans of Wall Street have to sit on the sidelines.
Banks have issued $8.4 billion in perpetual preferreds in 2012, a near doubling compared with the $4.5 billion of securities issued at this time last year, according to
, and as they brace for a big redemption of trust preferred securities starting in September, the trend may just be beginning.
Strong second quarter earnings growth from traditional lenders and a drop in first half Wall Street-based earnings to 2008 levels tells part of the story on a quickly shifting balance of power in finance. Still, investors should track the banks that take advantage of low interest rates to issue cheap perpetual preferred securities as a way to discriminate between those positioned to take on risk in coming years and those who will further retrench.
The key is that after large cap banks recapitalized during the crisis, the firms that move fastest in an industry-wide race to build new capital may actually be preparing for a lending and growth push, in coming years.
Already, recent financial moves made by the likes of Wells Fargo, US Bancorp, Capital One and JPMorgan, among others, signal that traditional mortgage, corporate and consumer lenders are positioning their balance sheets for an increase in lending - think risk - and hopefully earnings growth.
Meanwhile, standalone investment banks
(GS - Get Report)
(MS - Get Report)
and deleveraging conglomerates like
Bank of America
(BAC - Get Report)
A divergence in the growth profiles of America's largest banks may soon be seen in how they handle an upcoming refinancing of billions in trust preferred securities that are up for redemption starting in September and going through 2012.
Trust preferred securities will stop being counted as Tier 1 common capital in new post-
Dodd Frank Act
regulatory regimes, likely leading banks to redeem high-yielding securities issues - often carrying yields above 7% that reflect mid 2000s interest rate levels.
According to an Aug 17 Guggenheim Securities analysis, Bank of America and JPMorgan have over $20 billion of trust preferred securities up for redemption in the next year, followed by $17 billion-plus in redemptions at Wells Fargo. Morgan Stanley and Citigroup also have six and nine TRUPS up for redemption on September 20, respectively, which generally carry 6%-plus yields.
The big question is whether banks will look to replace those securities with other forms of hybrid capital -- perpetual preferreds -- that will count as equity by global regulators in coming years, and which may carry lower yields.
As trust preferred securities face an upcoming redemption schedule, some banks are replacing them with newly issued perpetual preferred securities - allowed in new regulatory regimes to count for roughly 1.5% of overall Tier 1 common capital - in refinancing's that may push down borrowing costs and increase interest-based earnings.
A recent $1.1 billion perpetual preferred offering by JPMorgan carrying a 5.5% yield and similar priced offerings by Wells Fargo, Capital One, BB&T and US Bancorp in recent months illustrate banks building low-yielding capital as billions in trust preferreds come up for redemption. Meanwhile, facing similar opportunities, Goldman Sachs, Morgan Stanley, Citigroup and Bank of America have been notably silent in 2012.
In June the
proposed enhanced capital requirements for large banks that exclude most trust preferred shares from regulatory Tier 1 capital. Now, under the Federal Reserve's proposed new capital rules, banks will be able to use noncumulative perpetual preferred for between 1% and 1.5% of their Tier 1 risk-based capital ratios.
With recent perpetual preferred financings in the 5% to 6% range poised to replace trust preferred securities issued with yields as high as 7.5%, Marty Mosby, a banking sector analyst with Guggenheim Securities says that recent offerings are a way to build regulatory capital, while also giving balance sheet flexibility to increase lending in coming years.
"[Banks] are just getting the cheapest source of capital they can to fund future growth," says Mosby of recent offerings. Still he notes that securities carrying 5% to 6% yields are likely only to be used by lenders who are already well capitalized, have strong growth prospects and expect their balance sheets to increase.
"[What] banks are finding is that these are being issued at very attractive yields," says Stuart Plesser, a banking sector credit analyst with Standard & Poor's. Plesser notes that other alternatives also exist.
Many banks may let high yielding trust preferred securities and debt financings to fund assets simply expire as they shrink their balance sheets. The issuance of perpetual preferred securities as a capital replacement, "could show the banks that are growing versus the ones that are not," says Plesser.
Already, investment banks are in a multi-year trend of cutting risky assets, while paring the debt needed to service them, in an industry deleveraging that matches new regulations. "[At] the moment, companies like Bank of America, Goldman Sachs and Morgan Stanley have made the decision to build very liquid balance sheets," says Richard Bove, a banking sector analyst with Rochdale Securities, who highlights significant cuts to capital intensive risk weighted trading and morgtage related holdings.
For investors looking at the wider relevance of a financial sector balance sheet overhaul, the takeaway may be negative even if some lenders gain a stronger industry footing. As banks build capital to excessive levels, Bove argues they do so at the expense of lending - an integral piece of the economy. "The common equity in the banking industry as a percentage of assets is higher than at any time since 1938," says Bove.
Where investment banks to begin issuing perpetual preferred securities it could be a signal of just how far rates have fallen. Were Goldman Sachs and Morgan Stanley to enter the market, Plesser of S&P says, "It would be more of a sign of just how low rates are." Last year, he notes, the European debt crisis precluded preferred security sales at current rates of 5% and 6%.
For more on trust preferred securities, see why
banks are squeezing investors
For more on the contrasts between U.S. bank earnings and business models, see why
Warren Buffet shuns investment banks
. See why Barclays' scandal was
born out of a derivatives bet
for more on regulating Wall Street.
-- Written by Antoine Gara in New York