A new security that dangles the prospect of earning a tax break while raising capital is creating a stir on Wall Street - and in Washington.
Banks are lining up to follow in the footsteps of Chase Manhattan Corp., which last month became the first to come to market with an issue of REIT preferred stock.
Proponents of the new security structure, in which a bank issues equity through a tax advantaged real estate investment trust, say it offers significant savings to an industry that must maintain capital to shield federally insured deposits from losses.
"This has the potential to be a very significant instrument in banking because of the enormous cost savings," said Christopher Hogg, vice president of Goldman, Sachs & Co., who says he has engineered similar products for the insurance industry. "It could be the best source of tier one capital because it is about half the cost of regular preferred stock.
"Banks don't necessarily need new tier one capital," he added, "but they would like to replace more expensive existing tier one capital with instruments that are tax-deductible."
Federal banking regulators, however, aren't satisfied that the security should qualify as tier one capital, and have been studying the matter.
REIT preferreds made their debut in September when Chase Preferred Capital Corp., a real estate investment trust created by Chase Manhattan Bank, issued $500 million of the preferred stock.
Chase Manhattan Bank funded the REIT with an infusion of $500 million in equity and an offering of $500 million in preferred stock, said analyst Thomas Stone of Duff & Phelps Rating Co.
The REIT will manage $1 billion in mortgages purchased from the proceeds of the common and preferred stock. Federal tax laws give allow the REIT to deduct the cost of dividends paid to the bank and preferred share holders.
At the same time it takes advantage of this saving, the bank expects to count the preferred shares toward tier one capital.
It is the tax deduction that comes with REIT status that is most attractive to bankers, noted Mr. Stone.
"By issuing a preferred stock out of a real estate investment trust, a bank is able to raise regulatory capital at an attractive tax-adjusted rate that could be significantly lower than the after-tax cost of traditional preferred stock," he said.
The Chase issue - priced at $25 a share with a dividend yield of 8.10% - was well-received by a predominately retail investors, as well as a handful of institutional investors. It also spurred other banks to file with the Securities and Exchange Commission to issuer REIT preferreds.
"Every big bank that has preferred stock outstanding is going to file," said Emanuel Friedman, chairman of Friedman Billings & Ramsey & Co. "Many of the thrifts will do it too, the bigger thrifts more so than the small ones."
But some observers are saying the securities may be too good to be true.
In the unlikely event of a bank failure, preferred shareholders' claims have priority over holders of common equity, naysayers point out. The seniority of the preferred stock makes it unacceptable as tier one capital, critics said.
Shortly after the Chase deal, Mellon Bank filed with the SEC to issue $200 million in REIT preferred stock. Others who have filed include Chevy Chase Savings, Washington, D.C., for $100 million; Provident Bank, Cincinnati, $50 million; Riggs National Bank, $4 million; and BankAmerica Corp., $1 million.
Wells Fargo Corp. is expected to file within a week, and Fleet is Financial Corp. is "strongly considering" it, said one bank debt trader.
But since the Chase issue, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, the Office of Thrift Supervision and other regulatory bodies have been holding interagency meetings over whether the securities should qualify as regulatory capital.
"The REIT preferred is dying a slow death due to significant regulatory hurdles" said one trader. "The regulators don't really like it and even if they allow it, (the conditions) will be so onerous that it won't be saleable."
FDIC spokesman David Barr said the regulators "are looking at the issue to see if this type of preferred stock can be used for capital purposes." Mr. Barr and spokesmen from the regulatory agencies declined to elaborate.
Mr. Friedman of Friedman Billings and Ramsey said that the REIT preferred structure would be more attractive to regulators if it offered a convertible feature allowing preferred stock to become common stock in the event of financial crisis.
"If the REIT is not convertible than you've simply created a disguised finance company," he said.
Mr. Hogg is unsurprised by the caution. Three years ago he created two similar products that called QUIP and MIPS which were unable to gain approval from banking regulators.
But he said the interest on the part of banks, and the Federal Reserve's approval of the Chase deal has given the REIT preferred structure some momentum.
"Activity has slowed a little because of these interagency meetings," Mr. Hogg said Wednesday. "But we expect this to be resolved in the next two days and I expect the outcome to be positive."
