Several banks are expected to be adversely affected by an Internal Revenue Service ruling last week that closed a tax loophole on a new security.
The security, known as step-down real estate investment preferred, died an early death after the IRS ruling last Thursday.
The issue, created and marketed aggressively by Bear, Stearns & Co. in the last three months, enabled issuers to pay as little as a 1% coupon per security.
Most of the issuance has come from industrial companies such as Time Warner Inc. and Dayton Corp. But capital markets experts say that several banks, including Republic New York Corp., which did two deals, Norwest Corp., and Barnett Banks Inc. jumped on the bandwagon as well.
The Federal Home Loan Mortgage Corp.-Freddie Mac-reportedly issued $3.5 billion of the securities, the most of any company.
The loss of the deduction should not hurt issuers' earnings per share but there could be minimal costs to unwind the security, said equity analyst Thomas O'Donnell of Smith Barney Inc.
Capital market experts likened the issuer's deduction to homeowners' taking deductions on the interest and principal of their mortgage.
Not only did the IRS ruling slam the door on any new issuance; it is also expected to be retroactive. Between $7 billion and $10 billion of these securities have been issued-all through private placements.
To issue the securities, companies created real estate investment trusts, which hold income-producing assets, such as mortgage loans.
The holding company then issues a new class of security, known as fast- pay preferred stock, to pay for the assets in the trust.
The fast-pay preferred stock is usually offered with a coupon of about 13%, but the tax deduction upon maturity, in 10 years, would reduce the cost to the issuer to around 1%.
Now that the IRS has closed the loophole, issuers who thought they would pay only 1% will have to pay 9% after tax-too much for a large issuer, said Jim Hofmockel, a capital markets associate in the financial institutions group of Salomon Brothers Inc.
What's more, the securities contracts included make-whole clauses which protect the investors from losses should the issuer have to call the issues early.
Although some investment houses are counseling their clients not to call the securities, capital market experts say it is just a matter of time before they do.
Issuing banks are not the only ones expected to suffer. For Bear Stearns, which has underwritten 80% of the deals, the demise of the step- down preferred is "embarrassing," and "damaging," capital markets experts say.
Bear Stearns is rumored to have charged fees between 1.5% to 2% "If you take Freddie Mac, that's about $35 million in fees, which is unprecedented for one deal," said one capital markets expert. "If I were a client, I'd start asking for my money back."
In addition to Bear Stearns, Morgan Stanley & Co. has been an underwriter of the securities.
"No one is a saint when it comes to this security," said Fred Sherrill, capital markets chief at Credit Suisse First Boston. "We looked at it seriously ourselves but decided that the product was too risky."
Both Bear Stearns and bank issuers declined to comment. Capital markets experts at first expected the new rule to affect the trust-preferred securities-another preferred security whose tax deductiblilty has been questioned.
But most capital markets experts insist that the impact will be negligible.
"The trust-preferred security has been around in many different forms, but this was relatively new," said Gregory Williams the head of financial institutions capital markets at Deutsche Morgan Grenfell. The step-down preferred "is categorically different and was viewed very negatively by the IRS."
