As banks begin to replace other forms of capital with trust- preferred securities, it could prompt ratings agencies to take a closer look at the banks' capital structures.
The Federal Reserve last October prompted a rash of issuance when it approved the use of trust preferreds by banks to raise Tier I capital.
The instruments are a cheap way to raise capital because financial institutions can take tax deductions on the proceeds.
But in November, the Fed said only up to 15% of a bank's Tier I capital can be composed of noncumulative preferreds-and ratings agencies are taking an even tougher approach.
Standard & Poor's has said when it evaluates how well capitalized banks are, it will allow only 10% of Tier I capital to consist of trust-preferred securities.
The S&P stance could start to affect the pricing of the debt instruments once banks start to use the proceeds of their issues to buy back shares or otherwise replace other forms of capital.
Bank ratings analyst Tanya Azarchs said that S&P expects some banks to push their Tier I ratio closer to 6.5%. "And a greater percentage of this 6.5% could be trust-preferred stock," she added.
"Trust-preferred securities are a weaker form of capital, because they have limited life" she said.
Ms. Azarchs explained that S&P finds perpetual securities to be a stronger form of stock. Trust-preferred securities usually have maturities of 30 years with a 10-year call.
Since the approval of trust-preferred securities, banks have issued close to $30 billion.
The most prolific issuers include Wells Fargo & Co., which has issued up to $1.65 billion, and BankAmerica Corp., which has issued $1.2 billion. J.P. Morgan & Co. has issued $750 million and recently filed with the Securities and Exchange Commission to issue $750 million more.
In early December, J.P. Morgan announced that it would repurchase $750 million of its stock with the $750 million it had raised from trust- preferred securities. Firstar Corp. announced a similar strategy shortly after.
Ms. Azarchs pointed out that many bank holding companies have aggressive buyback programs in place.
Standard & Poor's said that it does not intend to downgrade any banks which have issued substantial amounts of trust-preferred securities.
Bank bond analyst Allerton Smith of Donaldson, Lufkin & Jenrette pointed out that a ratings review could work to investors' benefit if it drives up the yield on the securities.
If the agency felt that the capital a bank counted was inefficient, that bank could get a downgrade in its preferred stock rating, explained Mr. Smith.
Investors could go to the underwriter and ask "what is the appetite of the bank for trust-preferred securities and then determine if that appetite is high enough to create a rating issue," said Mr. Smith.
The prospect of a downgrade should be priced into a security, said Mr. Smith. The difference between an A-rated security and an A2-rated security could increase the yield by five to 10 basis points.
According to traders, no such differential has emerged among the hybrid securities. But analysts say that is just a matter of time.
Michael Buchanan, who handles $25 billion in bonds for Conseco Capital Management, said that he has recently stopped purchasing trust-preferred securities because they have become more expensive.
However, he said he would consider buying them again if there were "at least a 10 basis point gain" and if he could determine how likely a ratings companies was to downgrade a bank.
