What Were Trust Preferred Securities (TruPS)?

What Were Trust Preferred Securities (TruPS)?

Let me explain what trust preferred securities, or TruPS, actually were. These were hybrid securities that large banks and bank holding companies issued, counting them in their regulatory tier 1 capital while allowing the dividend payments to be tax deductible for the issuer.

Here's how it worked: the bank would set up a trust funded with its own debt, then divide that trust into shares and sell them to investors as preferred stock. That preferred stock became known as a trust preferred security, or TruPS.

TruPS first appeared in 1996, but they drew heavy regulatory attention after the 2008-09 financial crisis. Because of reforms like Dodd-Frank and the Volcker Rule, most TruPS were phased out by the end of 2015.

Key Takeaways on TruPS

You should know that TruPS were a form of security issued by banks, blending traits of both debt and stock. They've mostly been eliminated through legal and regulatory measures post the 2008-09 crisis.

Banks or their holding companies issued them by creating debt-funded trusts, with TruPS representing shares of preferred stock in those trusts. Typically, these securities offered higher periodic payments than standard preferred stock and could mature in up to 30 years.

For issuers, a downside was the expense—investors required higher returns due to features like interest payment deferrals or early redemptions.

Understanding Trust Preferred Securities (TruPS)

TruPS combined elements of stock and debt. The trust gets funded with debt from the bank, but the shares sold are treated as preferred stock, paying out dividends accordingly. However, since the trust's funding is the bank's debt, what investors receive are essentially interest payments, taxed as such by the IRS.

These securities often provided higher periodic payments than regular preferred stock, with maturities extending up to 30 years thanks to the long-term debt backing the trust. Payments could be fixed or variable, and some TruPS allowed deferring interest for up to five years. At maturity, they pay out at face value, though issuers could redeem them early.

Companies created TruPS for their beneficial accounting and flexibility. The IRS taxes them like debt, but under GAAP, they look like equities on the books. The bank makes tax-deductible interest payments to the trust, which then distributes them to shareholders.

Remember this key point: when you buy a TruPS, you're purchasing a share of the trust and its assets, not direct ownership in the bank itself.

Special Considerations for TruPS

The Dodd-Frank Act of 2010 included provisions to phase out Tier 1 capital treatment for TruPS from institutions with over $15 billion in assets, starting by 2013. Tier 1 capital is what banks hold to absorb losses from bad debts, and TruPS previously counted toward that ratio.

Excluding TruPS from Tier 1 capital raised banks' funding needs and diminished incentives to issue them. The Collins Amendment even aimed to fully eliminate TruPS as regulatory capital.

On the cost side, issuing TruPS had drawbacks because of features like interest deferrals and early redemptions. These made them riskier for investors, who then demanded higher rates than on other debt. Plus, underwriting fees from investment banks added significant expenses.