The Federal Reserve's approval of the use of hybrid preffered securities as cheaper way to raise regulatory capital could trigger a raft of new issues.
Under a ruling issued earlier this week, bank holding companies will be allowed to issue tax deductible preferred stock that qualifies as Tier 1 capital.
The Fed's approval will unleash a deluge of issuance, said capital markets trader Rick Schwartz of Morgan, Stanley & Co., which is creating its own version of the hybrid securities.
"In my mind this is the most significant announcement to effect banking institutions that I can remember," he said. He expects the market for bank issued preferreds to grow in the next 15 months to roughly $20 billion.
The instruments are issued through a subsidiary, which lends the proceeds to the holding company as long-term subordinated notes. These qualify as Tier 1 capital and provide a tax benefit.
This class of securities was introduced in 1993, when Texaco issued monthly income preferred securities, known as Mips. Goldman, Sachs & Co. developed the Mips, and later introduced a quarterly verion known as Quips.
Trust originated preferred securities - Toprs - are similar securities offered by Merrill Lynch.
The Federal Reserve Board delayed the approval of the security, because the structure allows preferred shareholders to sue or take over the subsidiary if their dividends are suspended for five consecutive years.
That option raised doubts about counting the preferred proceeds as Tier 1 capital, which is supposed to cushion the federal deposit insurance fund against losses in the banking industry.
"But this argument is highly theoretical," said a senior staff member at the Federal Reserve who asked not to be identified. "In the last 10 years of preferred history, a bank hasn't suspended dividend payments for very long. On average they suspend for three or four quarters or they go under."
"When monthly income preferred securities were first issued, they did not meet bank capital guidelines for Tier 1 qualifications," said Scott Romanoff, a preferred stock specialist at Goldman.
He pointed out that insurance companies have issued more than $5 billion in hybrid preferred securities in the last year. They have had an unfair advantage over banks, he said, because these securities provide one of the most inexpensive ways to raise capital.
The victory for Mips and Toprs, however, sounds a death knell for REIT preferred, another hybrid preferred security that has been touted recently as offering cheaper Tier 1 capital. REIT preferred stock is issued by a tax-advantaged real estate investment trust.
Six banks each paid $100,000 to $200,000 to file documents disclosing plans to issue such securities, after Chase Manhattan Corp. issued $500 million of REIT preferred in September.
Market sources said Chase apparently will be able to count its REIT preferred toward Tier 1 capital. But they said the other banks will have to file plans to issue the hybrid securities instead if they hope to raise Tier 1 capital with a tax advantage.