Thursday, June 16, 2011

A TruPS UPdate

The TruPS CDO market has shown renewed signs of life over the last six or so months, for the first time really since 2007.

While the rating agencies continue to downgrade these bonds, and while certain serious risks remain to their performance, the market is (finally?) reacting to a number of positive developments in the underlying bank market. Several TruPS CDO securities, we believe, are now grossly mis-rated by the rating agencies. Our analysis suggests that many securities rated CCC or below will pay off in excess of their ratings-implied losses; some are likely to pay off in full.

Default Risk

A key risk for TruPS CDOs remains the default rate on smaller banking institutions. (Aside from banks strictly being pulled into receivership, TruPS CDO noteholders remain exposed to losses that may result on their preferreds to the extent troubled banks restructure, recapitalize or file voluntary petitions for relief under Ch. 11 of the Bankruptcy Code – see for example the cases of AmericanWest, or Builders Bank.)

On the plus side, the rate of bank failures has gone down from 2010. Adjusting for the cohort size – depending on the number of institutions reporting – we’re down from a default rate of approximately 2.05% last year to 1.37% annualized this year, based on the FDIC’s most recent quarterly report (March-end 2011).

This difference is substantial. From the looks of it, one of the key components of this reduction was that bank regulators were more successful in having banks absorbed through a merger process, evading failure: if we consider mergers plus failures, the sum is little different, from 4.62% in 2010 to 4.33% annualized for Q1 2011. But the distribution is now heavier towards the merger side of this equation, implying in the reduced bank failure rate.

The staving off of default, through the merger process or otherwise, almost always proves advantageous to TruPS CDO noteholders.

Balance Sheet Conditions & Outlook

The FDIC notes that “[more] than half of all institutions (56.2 percent) reported improved earnings, and fewer institutions were unprofitable (15.4 percent, compared to 19.3 percent in first quarter 2010),” and that net loan charge-offs (NCOs) have declined for the third consecutive quarter, resulting in an overall 37.5% reduction since March-end 2010. Deposit growth remains strong and the net operating revenues reductions were concentrated at the larger institutions – less of a concern for the average TruPS CDOs which are more heavily exposed to smaller rather than larger banks.

Banks' balance sheets, too, are in better condition: the ratio of noncurrent assets plus other real estate owned assets to assets decreased from 3.44% in 2010 to 2.95%. Also, while the overall employment of derivatives has increased almost 13% over the last year, the heightened exposure is more heavily concentrated among the larger banks. Based on PF2's calculations, if you exclude banks with more than $10bn in assets, you’ll notice a reduction of almost 30% in derivatives exposure over the last year.

These numbers are still much worse than pre-crisis numbers. Historically banks defaulted at an annual rate of approximately 0.36%, on a count basis. We’re at roughly four times that number now. Back in ’06, fewer than 8% of reporting institutions were unprofitable. We’re still at double that number. The ratio of noncurrent assets plus OREO assets to assets was slightly below 0.5% in 2006. We’re sitting at six times that level. But the trends are moving in the right direction – certainly if you’re an investor in the average TruPS CDO.

On the downside, the FDIC’s problem bank list has grown by a not-insignificant amount, from 775 banks (or 10.12% of the cohort) in 2010 to 888 banks (11.72% of cohort) as of March 31, 2011. TruPS CDO noteholders will doubtless hope that these troubled institutions turn around, or are merged or resolved in any other fashion that circumvents default on their trust preferred securities. (For TruPS CDO noteholders exposed to deferring underlying preferreds, the acquisition or merging of the deferring bank by or with a better-capitalized bank brings with it the possibility of the deferral’s cure.)

With the downward trend of bank default rates (and the possibility of deferrals curing), some of the more Draconian bank default probability assumptions can be relaxed, boosting values on TruPS CDO tranches.

We think the market is starting to appreciate this additional "value."

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