Global Credit Research CLO Research AC Rishad Ahluwalia (44-207) 777-1045 Maggie Wang (1-212) 270-7255J.P. Morgan Securities LLC TruPS CDO Primer Banking on TruPS (Excerpted from J.P. Morgan CLO weekly published on June 1, 2012) Summary and key themes So as to consider a different risk profile from CLOs, in this special feature we take a look at Bank Trust Preferred Securities (TruPS) CDOs. To review, TruPS is subordinated debt issued by banks (in CDOs, mainly non-rated or sub-IG regional, small, or community), thrifts, insurers, and REITs. Fitch1 tracks 1,813 institutions issued $37.7bn TruPS since 2000, mostly banks ($30.7bn) in CDOs. TruPS CDOs offer a pickup to CLOs, but the gap has narrowed. YTD, first-pay yields declined from 9.5-10.0% to 7.5-8.0% and second-pay from 13.0-15.0% to 10.0%-13.0%, with prices up $5-8 for both. In contrast, CLO first and second pay yields have largely remained around 2.5-3.0% and 4.0-5.0%. Given the rise in Eurozone stress, it’s possible there is some softness near term, but the lack of supply has cushioned price volatility. Investors should weigh the yield pickup with risks including subordinated exposure to the US banking sector, limited transparency, and low secondary market liquidity. Key themes: • Credit performance is pool-specific, but is generally improving. Fitch’s rate of new defaulted banks in TruPS CDOs dropped to the lowest level (0.11%) since 2Q 2008, versus 3.5% at the peak Banks may have increasing financial capacity to cure PIK’d interest payments as the economy improves. We survey cure data provided by the rating agencies and profitability data provided by our analysts There is upside from banks redeeming their TruPS and we discuss regulatory capital changes (e.g., Collins Amendment in Dodd-Frank), M&A, etc In addition to bond amortization upside from redemptions and M&A, TruPS CDO first pays also benefit from cashflow windfalls (asset PIK cures, etc) Since mid-April, $7.5bn of TruPS CDO notes (c. 25%) have been upgraded, potentially making them more capital efficient for some real money buyers Exhibit 3: Observed spread ranges (bp) for 87 TRUPS CDO tranches, by current Moody's rating Current Moo y !s rating #ig$ %& 'Aa1 to A() Mi %& '+aa1 to +aa() Su0 %& '+a1 to +() Distresse 'Caa1 to C) Count 12 1, 2, (/ Lo" 2*( --1 (1* 21, Mean *22 **( 1(2,1*#ig$ 1,120 2,,./ 2,-20 *,11- Source: J.P. Morgan, PricingDirect. As of May 1, 2012. Exhibit 4: Return on average assets ROAA of US banks with less than $15bn in assets 140% 120% 100% 80% 60% 40% 20% 0% -20% 1990Y 1991Y 1992Y 1993Y 1994Y 1995Y 1996Y 1997Y 1998Y 1999Y 2000Y 2001Y 2002Y 2003Y 2004Y 2005Y 2006Y 2007Y 2008Y 2009Y 2010Y 2011Y Source: SNL Financial • TruPS CDO tranches offer a significant yield sensitivity if interest rates rise, largely due to the longer maturities and deeper price discounts • We summarize a representative transaction and then compare risk/reward in TruPS CDOs with CLOs and SF CDOs in Exhibit 11. Secondary market snapshot Bank issuers in TruPS CDOs tend to be private or small regional and community institutions, with little asset pricing data available. As one snapshot on TruPS CDO liabilities, Exhibit 3 shows spreads grouped by current Moody’s rating for 87 tranches based on recent observations by PricingDirect, a wholly-owned subsidiary of J.P. Morgan Chase & Co. In general, first pays trade in a 7.5-8.0% yield, versus 2.5-3.0% in US CLOs, and one would have to go down to fourth-pay in CLOs (original BBBs) for similar yields. On the other hand, there is a high degree of price dispersion in TruPS CDOs, even in first pays, so picking points is vital. Our data indicates a range of 800-900bp in highest-rated bonds to a range of 2,000bp+ in lowest-rated bonds. • • • 1 Fitch Bank TruPS CDO Default and Deferral Index, Fitch, May 22nd, 2012. 1 5% 1. Our bank credit analysts have a positive view. Moody’s2 estimates that about one-third of all deferring banks in TruPS CDO portfolios have the financial capacity to resume their TruPS interest payments and become current on their cumulative deferred interest in the near future. Notably.+S.5% at the peak. but it is hard to estimate the timing and length of resumed interest payments. 2010 Mar. With the banking sector improving.Global Credit Research CLO Research AC Rishad Ahluwalia (44-207) 777-1045 Maggie Wang (1-212) 270-7255 J. As SNL financial data shows in Exhibit 4. 2008 /e0. Through the end of April 2012.0% 1. In terms of distress. % o -ollateral $.0% 3. Fitch measures default and deferral rates at 16. the rate of new defaulted banks in TruPS CDOs dropped to the lowest level (0.5% 3.0% 0.0% 2. 2008 Nov.4bn held across 83 TruPS CDOs were in default. the rate of new bank deferrals continues to decline year over year.5% 0. 2009 Nov.0% 0. 2010 Nov. 2012 # o !an"# $3 %on Mov&n' (vera'e) *+S.5% 2. as these securities were issued to obtain Tier 1 capital treatment. more deferring banks may be able to resume payments and default rates may remain low. 62 resulted in cures. 2008 Sept. If one has an optimistic view on regional and community banks and the US economy. 2011 Jan.5% 1. and are biased towards “beaten-up” regional banks which needed TARP support.5%. 2012 Mar.5% 2. Also.8bn of collateral held by 84 TruPS CDOs.5% 3. out of 626 deferrals since Sep 2007. 2011 Sept. with 3 their second time 2 Exhibit 5: Bank failure & corporate default rates 6% 5% 4% 3% 2% 1% 0% Co33ercial +an4 Failure 5ate A Cor6. as Exhibits 6-7 show. 2009 May-2009 Jul. which are typical in CDOs. but has since declined to 0. 2007 Jan. but with some challenges ahead. 2010 Jun. 204 bank issuers of circa $6. 2007 Nov. as a whole. 2009 Sept. and on a cumulative basis. 2011 /e0. 2010 # o !an"# $3 %on Mov&n' (vera'e) *+S. Moo y2s Exhibit 6: Rate of New Defaulted Banks in CDOs 10 9 8 7 6 5 4 3 2 1 0 4.+S.0% Source: Fitc$.0% Mar. 2008 Mar. 2010 Sept. /e0. the US commercial bank failure rate jumped to as high as 2. Source: Fitc$. 2012 Source: FD%C. there is an opportunity to access size at distressed pricing through TruPS CDOs. given the slow recovery since the recession.9% and 15. versus 3. respectively. For example. A key characteristic of typical TruPS is the issuer’s ability to defer interest payment for up to five consecutive years. Default 5ate +aa Cor6. 2009 Jun. In the bank collateral pool of TruPS CDOs. 2011 Jun. 2009 /e0. Default 5ate +a Cor6. 2007 /e0. 2008 Jun. 2011 Mar.0% 2. 2009 Sept. 2012. 2011 Nov.0% 1. without defaulting under the terms of the securities. “More Deferring Banks in TruPS CDOs May Resume Interest Payments”. 2 2012 . 2008 Mar. 2011 May-2011 Jul. Some institutions have come out of the crisis in much better shape than others. 2009 Mar.5% 0. To be sure. 2010 Mar. 2008 Sept. Exhibit 7: Rate of New Deferring Banks in CDOs 30 25 20 15 10 5 0 4.P. 2010 Jan. profitability is improving for banks of smaller sizes. 2008 May-2008 Jul. Moody’s Structured Credit Perspective. 2009 Mar. 2010 Sept. 2009 Jan. Default 5ate 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Mar. % o -ollateral $. Morgan Securities LLC Relative Value Themes (1) Improving banks and TruPS CDO performance The US banking sector is an improving credit story. 2007 Sept.0% 3. so CDO pool performance will vary. 2011 Sept. 2010 May-2010 Jul. and 368 deferring bank issuers were impacting interest payments on $5. April 20th. the rate of new cures is still minimal (Exhibit 8). 2008 Jan. Fitch observes that. 2011 Sept.35% at the peak of the last crisis.38% at present (Exhibit 5).11%) since 2Q 2008. 2012. 2011 Mar.000 $1. Morgan Securities LLC curing. 2008 Nov. it may make sense from a regulatory capital perspective for certain banks to redeem their trust preferreds. US Mid-and Small-Cap Banks Mergers & Acquisitions Weekly. 2010 banks with $15bn of assets or more won’t get Tier 1 capital treatment on TruPS issued. Exhibit 9: Total Number of Traditional Bank M&A Deals. On April 16th.5% 2.000 $0 0 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 YTD 2012 Source: SNL Financial.P. 2008 May-2008 Jul.htm economic rates and small issue sizes. they (a) become less capital intensive and (b) potentially attractive to new buyer bases. 4 The Collins Amendment in the Dodd-Frank Act establishes that any trust-preferred security issued after May 19. given that many of these institutions have equity or debt securities that is not in public capital markets. 2007 Nov.federalreserve. and an assumption that larger banks may redeem their trust preferred securities. because of the Collins amendment in Dodd-Frank Act on capital requirements4.+S.000 $1. 25% of outstandings) have been upgraded. please refer to the recent Federal Reserve press release: http://www.400. 2008 Sept. US Cash Flow CDOs Of Bank Trust Preferred Securities: Updated Methodology And Assumptions.000 $1. 2012 Mar. the “defer or cure” decision process may be less transparent to CDO investors. 2009 Jan. due to US regulatory changes that phase out Tier 1 capital credit for such securities. with about half taking place in 2011.5bn of TruPS CDO notes (c. ABA Meeting Takeaways on M&A. For any TruPS issued before May 19. there will be a three-year phase-in of exclusions starting in January of 2013 for banks and thrift holding companies with greater than $15 billion in assets.0% 2. 6 U. Total Assets Acquired (in millions) (RHS) No. Morgan. (2) The ratings upgrades of TruPS CDOs Moody’s and Fitch have been periodically reviewing and upgrading TruPS CDO tranches for some time. In general.000 $800.0% 1. S&P. of Deals (LHS) 3 . May 21. and S&P started doing so this year. large banks holding TruPS securities may redeem because of acquired TruPS at non3 Exhibit 8: Rate of New Cured Banks in CDOs 6 5 4 3 2 1 0 4. 2008 Jan. May 8. The ratio will probably increase with more bank industry consolidation and M&A5. 2012. 2011 May-2011 Jul. roughly 9.000. First.000 $400. 2007 Jan. 2009 Nov. %nclu es re7 eferrals.000 $600. 2010 Sept. banks with $15bn assets or higher no longer get Tier 1 capital treatment on their TruPS.P. a potential deferral cure credit in cashflow analysis for deferring bank trust preferred securities. with Total Assets Acquired ($ millions) 600 500 400 300 200 100 $1.000 $200. $7. due to M&A activity. April 16.gov/newsevents/testimony/tarullo20111206a .0% 0. % o -ollateral $. JPMorgan. 2011 Jan. 2010 will no longer be considered an element of Tier 1 capital. 2011 Sept. 2011 Nov. 2008 Mar. but with a higher percentage in pre-2005 vintages. for private small regional and community banks. S&P updated their rating methodology for US TruPS CDOs3. and our equity research analysts believe there should be more bank consolidation but with two impediments: 1) future regulatory changes and 2) valuation risk6. US Banks Equity Research. Mid. 2009 May-2009 Jul. As a result.9% of deferrals have cured their interest obligations since September 2007. but at least 10 that cured are deferring once again. 2010 May-2010 Jul. 2010 Mar.0% 3.5% 1. (3) TruPS redemption and bank sector M&A trends The other trend worth mentioning is TruPS redemption by large banks or through bank acquisition. For more information. Second. 5 Sept.and Small-Cap Banks.5% 3. such as real money. US Banks Equity Research. 2012.0% Source: Fitc$. depending on their financials. 2010 Jan. 2009 Sept. 2010 Nov. All in all. J.600. M&A activity is at a low point now (Exhibit 9). Since mid-April.200.S. The new criteria include a decreased emphasis on front-loaded defaults (which are generally more stressful on cashflows) for lower ratings. So. 2009 Mar. We observe TruPS CDOs normally have 0-20% exposure to large banks.5% 0. As ratings for some tranches gravitate towards IG.Global Credit Research CLO Research AC Rishad Ahluwalia (44-207) 777-1045 Maggie Wang (1-212) 270-7255 J. 2012 # o !an"# $3 %on Mov&n' (vera'e) *+S. 0< .P. etc) this could make the environment more challenging7. but as banks redeeming their TruPS generate amortization proceeds. tranche rating upgrades. For instance. first pay bonds stand to benefit directly by proceeds from redemptions. • • 7 What Is Priced in? Looking at Potential Outcomes of the Moody's GCMI Review. who are very yield driven. . and therefore associated drag Moody’s has announced they will be downgrading Global Capital Markets Intermediaries (GCMIs) by mid-2012 due to credit concerns (macro uncertainty. with a relatively high sensitivity to future changes in interest rates. While not directly impacting small and community banks in TruPS CDO pools. banks that do not have enough capital and/or liquidity to redeem would be the riskier ones and remain in the pool). eal re6orts.0< .2< 21. %N89:. • There are risks of timing redemption and deferral cures.5% with a 100bp forward curve increase..1% to 2. It is challenging to keep abreast with news information on the underlying issuers.(.5% to nearly 9. this generates potential negative or adverse selection risks for the mezzanine tranches (as presumably.0. 4 ..*< 0.. if deferring banks resume interest payment. US Banks Credit Research.1. regional or community banks (and mostly private ) Exhibit 10: Sample analysis (PRETSL 19) Asset +rea4 o" n Par '..3n) Perfor3ing assets Deferring assets Defaulting assets . among other factors.-2 .3n) +an4 %nsurance 59%8 Cre it Analy sis Par '. and long-term interest rate rises.(1 /0. low growth. The trade is supported by improving bank performance and capital ratios.(1 Source: J. With US interest rates at very low historical levels. (4) The structure / OC test play As the majority of bank TruPS CDOs are failing their senior OC tests. Key risks and sensitivities We see opportunities in first pays and selected short duration second pays.2< 22.9% with the same interest rate increase.P.11(.-0.*< 100. counterparty confidence).0< 100. Morgan Securities LLC Redemptions benefit first pay bonds. in a typical seasoned first-pay TruPS bond priced in the $50s area. there is an opportunity to have an embedded rates play. higher rates... May 9.. resumed interest payment and excess interest flowing through from swaps maturing. For example. which is important to typical fast money players.-. all else equal. (5) Floating rate option Last but not least.00 /1./1 .00 . structural paydown.. the yield rises from about 7. the yield rises from about 2. for a typical seasoned CLO firstpay bond priced in the mid-$90s. etc. to the extent the banking market is generally impacted (higher funding spreads. In contrast. Morgan. TruPS CDOs are a cheap floating rates option. and valuing associated Senior OC passing and junior class leaks Investors need to bear in mind the long swap maturity.1. given the deeper discounts and longer dated maturities. 2012. Any steepening of the forward interest rate curve benefits price and yield. typically 75-150 small. senior bond holders are entitled to a windfall from excess interest (current coupon + PIK’d interest) amortizing the seniors..1.0< . There are several key risks/sensitivities in the sector when analyzing bank deferral/default assumptions for a TruPS CDO: • Most investors need to get access to the collateral from a dealer and most use S&L’s database to get solid credit analysis on the underlying.(.-0.Global Credit Research CLO Research AC Rishad Ahluwalia (44-207) 777-1045 Maggie Wang (1-212) 270-7255 J.. 0< Floating 'LA 2-06) 2.006) (-7. fe" 3anage . The performing asset pool ($463mn) is greater than the combined A1 and A2 tranches ($446mn). but in general many first-pays (A1s) could be covered. current typical pool rating. any excess interest.e. first-pay bond spread range. With A1s generically in the $50-60 and A2s in the $35-45 context. Preferred Term Securities XIX (PRETSL 19).10n A3orti@ing /A years /00 7 *0006 10.0712. This is only one example.-006 7 --006 /.7(0< 1*72(< US TruPS CDO . with second-pay (A2) coverage contingent on performance in the remaining assets.7/ yrs) 1007200 ?0ligors Manage . and means cashflows are being diverted to pay down the senior notes (A1 and A2 factors of 0. current typical pool diversity/number of obligors.years 1(006 7 1/-06 2.91 and 0.P. among other factors. a CDO of mostly bank TrupS (70% of pool) issued in late 2005. there may be upside for investors with a relatively long time horizon.0< 2-7(0< US SF CDO .. market size.. . Morgan Securities LLC Exhibit 11: Comparing TruPS CDOs to CLOs and SF CDOs US HY CLO Outstanding Market Size Collateral Typical pool diversity Manage ent Type !eneric Deal Size Cas" #lo$ Structure Current %verage Li#e &#irst pay 'ond( First pay spreads Yield on #irst pay First pay coupon %%% Su'ordination at issue %% Su'ordination at issue Source: J.98 at present).003n A3orti@ing (7. but by a small amount suggesting principal repayment risk for the A2s depending on how the deferring obligors behave. The Class A OC ratio of 106% is failing its 128% threshold.2*00n ++=+ +roa ly syn icate le>erage loans '.Global Credit Research CLO Research AC Rishad Ahluwalia (44-207) 777-1045 Maggie Wang (1-212) 270-7255 J. in Exhibit 11.-003n A3orti@ing 10A years .P. insurance an 59%8) '-7(0 yrs) /-71-0 ?0ligors Static.(000n Non7agency A+S an ot$er CD? /-71-0 ?0ligors Static .-7(. collateral buckets. This is fairly typical in the market. 5 . we compare some of the key features of TruPS CDOs versus CLOs and SF CDOs (i. Morgan.0< Floating 'LA.0< Floating 'LA(07-006) 1*7(0< *72-< Sample analysis Exhibit 10 summarizes a representative TruPS CDO. when swaps mature and any deferring asset coupon turning back on.(07. t$rift.00n +++=++=+=non7rate trust 6referre securities '0an4. To conclude.07*. etc). P. Morgan Securities (Far East) Ltd. Morgan India Private Limited. having its registered office at J. with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers.com/publications/risks/riskstoc. Morgan Tower. and Underweight (over the next three months. competitive factors.P.P. 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