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Should You Mourn For JPMorgan's Trust Preferred Securities?

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I spend a good 40% of my day mindlessly refresing JPMorgan's page at the SEC hoping they've filed a new structured notes prosupp so I was excited to see this:

Following the Federal Reserve’s announcement on June 7, 2012 of proposed rules which will implement the phase-out of Tier 1 capital treatment for trust preferred capital securities, JPMorgan Chase & Co. announced today that each of the trusts listed below will redeem all of the issued and outstanding trust preferred capital securities identified below on July 12, 2012 pursuant to redemption provisions relating to the occurrence of a “Capital Treatment Event” (as defined in the documents governing those securities). In each case, the redemption price will be 100% of the liquidation amount of each trust preferred capital security, together with accrued and unpaid distributions to the redemption date. The redemptions will be funded with available cash.

You can go read the chart but there's a total of just under $9bn of trust preferred securities with a weighted average interest rate of just over 7%, all being redeemed at par.*

These trust preferred securities are, to simplify ever so slightly, very long-term very subordinated debt securities that qualify as capital for JPMorgan: for the purposes of convincing regulators that JPMorgan is well capitalized, they were roughly as good as common stock, but they are cheaper for the bank because they cost only a 5.85 to 7% (tax deductible) coupon, vs. JPMorgan's 16% trailing return on tangible common equity or its 13-ish% trailing earnings yield or however you want to compute the cost of its common stock. After last week's announcement of revisions to the capital rules, these securities will (eventually) no longer qualify as useful "tier 1" regulatory capital. Under the terms of the securities, if they will no longer qualify as tier 1 JPMorgan has the right to get rid of them, since they were a capital-regulation arbitrage to begin with. And so they will.

WHAT COULD BE MORE BORING. Still, two idle thoughts. One is that the regulators' announcement last week saved JPMorgan significant money. JPMorgan's 10-year CDS is about 193bps and its long-dated bonds are yielding in the 5% neighborhood, making this 7% paper not that attractive for something that looks like debt. While trading data (that I've found) for the preferreds isn't great, if you assume that the market level is around 6% then buying back these 7%-coupon instruments in the market should cost around $10bn,** meaning that the new regulations allowed JPMorgan to save about $1bn buying in its debt, or debt-like-things. This won't increase accounting earnings, sadly, in a quarter that could use it, but it's still a compelling economic trade: JPMorgan is getting paid $1bn to take this opportunity to get rid of these securities.

So that's nice. But maybe it isn't so nice. This trade is a valuable for JPMorgan because it "will be funded with available cash," and it's safe to say that JPMorgan can get cash for cheaper than 7%. Way cheaper in fact. The Journal this morning ran a smart piece about how US banks are increasingly turning to short-term funding instead of longer-term debt, which is risky because short-term funding markets have been known to seize up and blow up banks before:

Awash in deposits, many big U.S. banks aren't replacing some debt as it comes due. Combined, long-term debt at the four biggest U.S. banks — J.P. Morgan Chase, Bank of America, Citigroup and Wells Fargo — fell 12% between the end of 2009 and the first quarter of this year.

Superlow interest rates are a big reason. With their net interest margins falling, banks are trying to retool their cost of funding. Although debt is historically cheap, it is still more expensive than near-zero-cost deposit funding. On Bank of America's first-quarter earnings call, for example, finance chief Bruce Thomson noted that the bank was focused on shrinking its "debt footprint" as it tries to bolster its margin.

While European banks would kill for that luxury, there is a risk: It potentially places deposits, and so taxpayers, at greater risk.*** ... One solution: Require systemically important banks to issue more long-term debt. That approach was advocated in a recent comment letter to the Federal Reserve from former FDIC Chairman Sheila Bair; Anat Admati, a professor at Stanford University's graduate business school; Simon Johnson, a Massachusetts Institute of Technology professor, and Richard Herring, a professor at the University of Pennsylvania's Wharton School.

As they noted, this would extend the average maturity of firms' liability structures, lessening banks' reliance on short-term funding, including deposits.

If you think that banks should be more long-term funded, then you will love things like these trust preferred securities that have 30-year maturities. The problem is that there is some tension between this desire and a desire for bank capital to be real capital, that is, perpetual simple fully loss-absorbing common equity. Regulators don't love treating trust preferreds as capital because they have fixed (albeit deferrable) interest payments, fixed maturities, and investors who elieve that they're fixed-income instruments where they can park their life savings for a nice yield. So it's harder, in some loose systemic and reputational way, to not make payments on a trust preferred than it is to turn off a common stock dividend or otherwise impose losses on common equity holders. And so if you want robustly capitalized banks, you may not want them to treat these beasts as capital.

And so the latest rules disqualify them from being treated as tier 1, almost-as-good-as-common-equity capital, and so - and so they're basically useless from a regulatory perspective, and might as well be replaced with overnight secured funding as long as its cheaper. But that's not entirely right from a risk perspective. Paying off long-dated securities (even if they're complex, ungainly, and held by widows and orphans) with "cash on hand," when your assets are ~50% funded with deposits and ~80% funded with short-term liabilities,**** reduces your duration and increases your reliance on short-term funding markets. JPMorgan can handle it - they're very well managed - but the likely wave of trust preferred redemptions sparked by the new, stricter capital rules may not entirely increase the safety of the banking system.

JPMorgan Chase Announces Redemption of Approximately $9.0 Billion in Aggregate Amount of Outstanding Trust Preferred Capital Securities [EDGAR]
U.S. Banks Face Different Sort of Debt Dilemma [WSJ]

* Here is a more useful chart; the prosupps are here, here, here, here, here, here, here, here and here:

** That's =-PV(0.06,20,0.07021 * 8981288000,8981288000) if you're playing along at home. Why assume 20 years remaining life? Why not? Incidentally some but not all of these preferreds have optional call provisions with a T+25bps or T+37.5bps makewhole; with a 2.77% 30-year treasury, a 3.15% makewhole rate (2.77% + 0.375%), and an arbitrary 20 years left, you get a $14bn cost of calling all $9bn worth using the optional call instead of the regulatory call, which allows JPM to call them at par with no makewhole.

*** Eliding sort of a lame explanation for why from the Journal about how debt should take losses before deposits which, fine, but I feel like the better explanation is just that the more long-term funding you have, the less likely you are to be blown up by dislocations in the short-term funding markets. Consider Morgan Ricks etc.

**** Just taking $2.3trn of total balance sheet, of which $189bn of stockholders' equity and $255bn of long-term debt, and I assume the rest is short-term. Data from page 87 here; you could quibble with that bucketing but whatever.


Let's Talk About: Basel III

The Fed last night unleashed eight zillion pages of Basel III implementation on the universe and I'm tempted to be like "open thread, tell us about your hopes and fears for capital regulation." So do that! Or don't because it is super boring, that is also a valid approach. Still I guess we should discuss. Starting slow though. Banks have to have capital, meaning that they have to fund some of their assets with things that are long-lived and loss-absorbing, like common equity, rather than with things that have to be paid back soon and at face value. The reason for this is that the rest of banks' assets are funded with things that we really do want to be paid back soon and at face value, like deposits, and if the value of those assets declines you don't want those deposits to be wiped out. The rules say that you need capital equal to a percentage of your assets. The game is deciding (1) what that percentage is, (2) what is capital (proceeds from selling common stock, and actual earnings, yes, but, like, deferred tax assets?), and (3) how you count assets (you might want more capital to shield you from losses in, say, social media stocks than you would to shield you from losses in Treasury bonds, so regulators use "risk-weighted assets," so that $1 of corporate bonds counts as $1 of assets, $1 of Treasuries counts as $0 of assets, and $1 of Facebook stock counts as $3 of assets*). Anyway, here are the required capital levels:

JPMorgan's Voldemort Probably Isn't That Magical

John Carney has hilariously convinced a bunch of people that JPMorgan whale-wizard Bruno Iksil could actually be running a synthetic bank on top of JPMorgan's actual bank. The theory, propounded to him by a mysterious trader and sort of supported by an old PIMCO client note, is that Iksil was tasked with hedging JPMorgan's inflation risk and did so by putting on a trade that was (1) long TIPS (for the inflation) + (2) long [write protection on] CDX (for the yield). Now I will tell you a thing, which is that I hedge my inflation risk by being (1) long TIPS (for the inflation) + (2) long MegaMillions tickets (for the yield),* but nobody calls me Voldemort. Here is Doug Braunstein's theory about Iksil: On a conference call with analysts, Braunstein said the positions are meant to hedge investments the bank makes in “very high grade” securities with excess deposits. (J.P. Morgan has some $1.1 trillion in worldwide deposits.) Braunstein said the CIO positions are meant to offset the risk of a “stress-loss” in that credit portfolio. He added the CIO position is made in line with the bank’s overall risk strategy. What can that mean? Presumably the sensible view to take from this is that this is actually part of a "stress-loss" hedge; the CIO is short (bought protection on) a lot of shorter-dated corporate credit and funds it by being long (selling protection on) a lot of longer-dated (5-year) corporate credit, so as to be relatively DV01-neutral but long jump risk. This has the advantage of (1) actually hedging a stress loss in high-grade short-term corporate securities, (2) fitting in with the relative lack of noise in the CIO portfolio,** (3) being what people have told Bloomberg he was doing, and (4) being what JPMorgan has actually said it's actually done in the CIO during the crisis. So it's probably true no? But it's fun to pretend! If you pretend Carney is right you can have one of two views.*** One is Izabella Kaminska's, which is "sure, I guess this is a hedge, but boy is it a mysterious one." You can buy this if you have - as she does - a pretty postmodernist view of what a hedge is. I do too, mostly.