Bank of America 'Best Positioned' for Trust Preferred Switch

NEW YORK ( TheStreet) -- A bitter pill for investors could be a nice earnings boost for for Bank of America.

As required by the Dodd-Frank legislation, the Federal Reserve in June proposed enhanced capital requirements for large banks that exclude most trust preferred shares from regulatory Tier 1 capital. Since this is considered a "capital treatment event," banks have been redeeming their trust preferred shares, even before the call date, often at face value, despite any premium the market previously placed on trust preferred shares paying high dividends.

Regional banks have been quick to redeem the trust preferred shares this year, even though the proposed capital rules phase out the inclusion of most trust preferred equity from Tier 1 capital over a four-year period. Several regionals, including BB&T ( BBT) and U.S. Bancorp ( USB), have moved aggressively to redeem their trust preferred shares, while taking advantage of the historically low rate environment to issue lower-paying non-cumulative perpetual preferred shares, which can be included as Tier 1 capital under the new rules.

While it's obvious that the new capital rules are squeezing investors, it's not a complete win for the banks. The banks are indeed getting a wonderful short-term benefit in being able to redeem the trust preferred shares -- even the ones that hadn't reached their call dates -- without paying a market premium, but the increased capital ratios required under the new rules mean that most of the large banks will pay more in dividends on newly issued preferred shares than the interest they are saving on the redeemed trust preferred shares.

This will happen because the new capital ratio requirements are so much higher than the old ones, and the large banks will all look to have preferred shares making up 150 basis points of their Tier 1 capital ratios, since this is the limit under the proposed rules, and the banks prefer to reach this limit, rather than hold additional common equity.

JPMorgan analyst Vivek Juneja on Tuesday said that "on a pro forma fully phased in basis, to account for full TruPS redemption and likely Preferred issuance (including what has been done to date in 2012)," Bank of America ( JPM) "America would likely be the only bank with a net EPS benefit in our universe."

Juneja also said that on a fully phased in basis, with all trust preferred shares being redeemed and required perpetual preferred shares being issued to more than make up the difference, Regions Financial ( RF), SunTrust ( STI) and Citigroup ( C), "would see higher EPS hit than peers."

Among large regionals, Juneja expects PNC Financial Services Group ( PNC) to complete the redemption of all of its trust preferred shares before the end of the year.

Juneja said that "large cap banks have redeemed or announced plans to redeem $38 bil in TruPS in 2012, with interest costs averaging 6.7% - well above deposit and long-term debt rates," and that the redemptions of trust preferred shares have helped net interest margins "hold up better than feared by reducing funding costs to offset some of the decline in asset yields." But trust preferreds that have not yet been called "can no longer be called due to regulatory change - securities will need to reach their call date in order to be eligible to be redeemed," and others "may not be called near term because they are floating rate or hedged and provide attractive low cost long-term debt funding," according to the analyst.

The largest U.S. banks have lagged the regionals in redeeming trust preferred shares. Juneja estimates that at the end of 2012, Citigroup ( C) will have $12.4 billion in remaining trust preferred shares, with $10.5 billion for JPMorgan Chase ( JPM), $10.1 billion for Bank of America, and $4.8 billion for Wells Fargo ( WFC).

For Citigroup, things get a bit complicated, because the Federal Deposit Insurance Corp. is holding $3.025 billion of trust preferred shares -- including $800 million on behalf of the U.S. Treasury -- and it is "unclear if FDIC will allow these TruPS to be redeemed before 2014 call date, but if so, Citi will likely have to call at par, which would be a hit to capital and book value," according to Juneja, who added that "Citi also has $2.4 bil of TruPS with average coupon of 7.9% that are not callable until 2015 or 2036."

The analyst added that "Bank of America has called nearly $10 bil of TruPS in 2012, but still has $10 bil outstanding, most of which is callable," and that Wells Fargo's outstanding trust preferred shares "are also mostly callable."

JPMorgan estimates that banks under its coverage have "redeemed over $38 bil in TruPS, but issued only $10 bil in Preferred stock thus far in 2012," and estimates that the group "would need to issue about $40 bil of additional Preferred stock to reach 150bp of current risk weighted assets." which is the limit of preferred equity included as Tier 1 capital under the Fed's proposed rules. Juneja expects all of the large banks to have preferred shares making up at least 150 basis points of their Tier 1 capital ratios. "Very few banks are likely to hold excess Tier 1 common equity instead of issuing Preferred stock as it is a more expensive form of capital," he said.

The money center banks "would need to issue the most Preferred stock based on current risk weighted assets - $18 bil for Citi, $8 bil for Bank of America and $8 bil for Wells Fargo," Juneja said, estimating that Citigroup's 2013 earnings under this scenario would decline by 11 to 18 cents a share, or between 3% and 4%. "In contrast, for Bank of America, we calculate a net EPS gain of $0.03 or 3% of our 2013 EPS forecast, as it has a large amount of high cost TruPS outstanding (much of this came along with its acquisitions) and has some Preferreds outstanding already."

Among the large regional banks, "Regions and SunTrust are likely to see higher impact at about 5% hit to 2013 EPS. WFC, PNC, BBT, and USB would have the least impact - modest 0%-1% hit to 2013E EPS," Juneja said, adding that U.S. Bancorp "does not need to issue any additional Preferred stock as it issued a large amount this year and the impact is already in the EPS run rate."

Some of the largest banks are likely to see their balance sheets continue to shrink, which is a very important strategic goal for Bank of America and Citigroup. Juneja said that "for BAC, if risk-weighted assets were $50 bil lower, it would need to issue about $1 bil less and EPS accretion would increase a tad but stay around 3% or $0.03," and that for Citigroup, a $100 billion reduction in risk-weighted assets, which is quite possible as the company's Citi Holdings subsidiary winds down, "would reduce Preferred issuance by $1.5 bil to about $17 bil and EPS dilution to 3% from 4% currently."


-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.