Trust Preferred Securities (TPS) are hybrid securities

• Rely on a complicated structure
  to obtain favorable tax and accounting treatment
• Treated as debt for income tax purposes,
  so interest is tax deductible

• Can be counted as equity for regulatory capital
  and credit rating purposes

• e.g., Federal Reserve Board policy is to count TPS as
  Tier 1 capital for bank holding companies subject to limits
• Since mid-1990s, TPS have grown into a sizeable source of equity for bank holding companies, utilities and other issuers

• Original deals depended on favorable GAAP treatment

• FIN 46 (2003) undercut this treatment

Typical structure

• Company organizes a wholly-owned business trust
• Trust sells TPS to investors
• Trust uses proceeds to acquire
  a debenture from the company

• Interest paid on debt is used
  to pay preferred dividends on TPS
• Interest expense is tax-deductible by the company
• If the company instead issued preferred stock directly,
  it wouldn't be tax-deductible

• Favorable GAAP treatment depends on Company consolidating the trust for GAAP purposes

• Debenture is eliminated as intercompany debt
• TPS is treated as minority interest
  on the company's balance sheet
• Thus, considered equity, rather than debt, under GAAP

Recent developments

• Regulatory agencies are looking past GAAP issues

• e.g., Federal Reserve still counts TPS as Tier 1 capital
• Notwithstanding effect of FIN 46

• Moody's has begun to give equity credit to new structures

• Reverses Moody's historical resistance to giving TPS
  any equity credit

• Investment banks are creating new structures in response

• Lehman's Ecaps was the first new structure used in US
• Followed innovations used by European issuers

FASB revised GAAP treatment for consolidation of variable interest entities

• By adopting FIN 46 2003
• When applied to TPS, effect is to deconsolidate the trust that issued the TPS
• Undercuts favorable GAAP treatment
• As regulatory capital treatment generally follows GAAP, raises issues over regulatory treatment
• See FIN 46

Federal Reserve still counts TPS as Tier 1 capital

• Notwithstanding accounting changes wrought by FIN 46
• Prior FRB policy was to credit TPS,
  generally up to 25% of Tier 1 capital

• TPS must allow for interest deferral for 20 quarters
• Underlying debentures must be subordinated

• Policy applied to bank holding companies,
  but not to banks

• FRB has more flexibility in setting capital requirements for bank holding companies
• Not restricted by GAAP
• Nor Basle accord, which only applies to banks

• Responding to FIN 46, FRB issued a supervisory letter 2003

• Affirmed continued application of favorable FRB policy pending further study

• FRB issued proposed rules May 2004
• FRB issued final rules March 2005

• Alston & Bird commentary
• Simpson Thacher commentary

Moodys has begun to give equity credit to new structures

• Gives 75% equity credit (25% debt) to qualifying issues

• Moody's basket D treatment
• Reverses Moody's historical resistance to giving TPS
  any equity credit
• As Moody's used to give 0% credit to trust preferreds
• Even though S&P gave 100%, subject to limits

• Thus, new structures get more equity credit from rating agencies than typical trust preferred

• Equity credit is comparable to mandatory convertibles

• But issues price like typical trust preferred

• Which is better than a mandatory convertible preferred

Investment banks are creating new deal structures

• Lehman's Ecaps was the first new structure used in US

• Enhanced capital advantaged preferred securities
• Lehman's first deal is for itself - Aug 2005
• Followed innovations used by European issuers

• Differences in Ecaps from trust preferreds:

• 60-year maturity (rather than 30)
• Stronger mandatory deferral features:
  In certain events issuer must convert to common stock or qualifying perpetual preferred stock
• 12 year deferral period (rather than 30)

• Other issuers and underwriters have followed Lehman's lead

Commentary

• CFO article 11.30.05
• Chameleon bonds 11.30.05
• Business Week article 3.13.06
• Fitch rating presentation
• Bankruptcy issues

Wachovia Securities introduces WITs

• Wachovia Income Trust Securities

• "Tier 1, tax deductible, subordinated debt"

• Fixed-to-Floating Rate variant on trust
  preferred structure

• Uses five-year, fixed-rate junior subordinated notes and a forward purchase contract for floating rate preferred stock
• In year five, issuer goes from making an interest payment on the initial note to a dividend payment on the perpetual preferred
• So that after-tax costs to issuer can increase substantially in year five

• Federal Reserve Board will treat WITs as qualifying
  Tier 1 capital

• Result criticized by WB competitors,
  including Merrill Lynch
• Because of potential increase in cost after year five

Wachovia brings first WITs issue to market for itself

• $2.5B issue of 5.80% Fixed-to Floating Rate
• Description

SEC filings

Enables smaller banks to issue TPS on a collective or "pooled" basis

• Offsets the higher fixed costs of issuing TPS
  that would otherwise be prohibitively expensive

Commentary

• American Bankers Association webpage
• FRB - Chicago article

FIN 45 (Accounting for Guarantees)

FIN 46 (Variable Interest Entities)

Balance Sheets (Re: FASB 150)