Investing in U.S. Financials via TruPS CDOs

By: Anthony Scaramucci and Troy Gayeski

On May 24th, President Trump signed into law the “Economic Growth, Regulatory Relief and Consumer Protection Act,” which recently passed both houses of Congress with strong bipartisan support. The law creates a new, less onerous regulatory framework for the U.S. banking system, in particular regional and community banks.

At SkyBridge, we construct portfolios with a top-down approach regarding broad economic conditions, including expectations for regulatory changes. Starting in early 2016, we began building a position in Financials via TruPS CDOs, which is a low beta, cash flow generative strategy focused on the U.S. community and regional banking sector via trust preferred securities (“TruPS”) collateralized debt obligations (“CDOs”). The theme currently represents around 25% of our exposure across portfolios.

SkyBridge Partner and Senior Portfolio Manager Troy Gayeski discussed our Financials via TruPS CDOs theme on his most recent Bloomberg TV appearance.

Our base case for Financials via TruPS CDOs priced in modest regulatory relief regardless of the outcome of the presidential election, but when President Trump won the presidency, we began to increase our exposure to the strategy in anticipation of more muscular tax reform and executive branch regulatory reform. However, even our bull case did not price in the extent of bipartisan legislative regulatory relief provided by the new law.

The Financials via TruPS CDOs theme has performed well since inception, and we believe recent regulatory changes could provide an additional tailwind for this strategy.

Background on TruPS and TruPS CDOs

TruPS are legacy debt securities issued by banks or bank holding companies with less than $50 billion in assets. They are essentially debt-funded trust shares that throw off cash flow similar to preferred stock. Prior to the financial crisis, banks often issued TruPS in lieu of subordinated debt because they counted as Tier I capital while possessing flexible cash flow characteristics. The TruPS CDO market originated in the mid-1990s as a way to help these small banks improve issuance pricing and volume. It performed well and grew to around $60 billion prior to the crisis, when prices collapsed and new issuance effectively ended. 

Exacerbating the post-crisis decline of the TruPS CDO market was the fact that regional and community banks themselves were the largest buyers of the securities, which they used, in part, as geographic diversifiers. However, regulators, noting the danger of banks doubling down on the credit health of the U.S. financial system, forced small banks to sell off their TruPS CDO exposure in the years following the crisis. Dodd-Frank created significant long-term inefficiencies in the TruPS CDO market, which helped generate what we believe to be the current attractive opportunity set.

To this day, few managers understand these complex securities, including the credit quality trajectory of the underlying banks and payment schedule of the CDO capital structure. As a result, this niche capital market exposure is unique not only for the asset management business, but also within the hedge fund industry.

Financials via TruPS CDOs Investment Thesis

SkyBridge’s investment thesis for the Financials via TruPS CDOs theme remains driven by several core factors:

1.     Low dollar prices and relative value proposition of TruPS CDOs given the substantial improvement of the U.S. banking system’s credit quality since the end of 2011. TruPS CDOs traded at par for almost their entire existence before collapsing to 10-40 cents on the dollar during and after the acute stages of the financial crisis. They recovered to 62-90 cents by the early summer of 2015, then collapsed again back to the high 30’s-high 50’s range early in 2016 despite continued improvement in U.S. bank fundamental credit quality during that period. TruPS CDOs finally began to recover in earnest during the middle of 2016 and now trade between 50-80 cents, but we believe prices could still have more upside, especially in light of recent regulatory changes.

2.     Improving cash flows due to rising interest rates and increasing net interest margins. TruPS CDO’s are floating-rate securities that benefit from higher short-dated interest rates tied closely to the Fed Funds rate, as opposed to traditional fixed-rate bonds, which carry duration risk. When the Fed raises rates, investors in the securities are pleased for two reasons: 1) interest payments go up and investors receive more cash flows, and 2) the cost of the TruPS liability to the bank goes up more than cost of their deposit liability (since deposit rates have a lower sensitivity to Fed rate increases than the TruPS payment, which is one unit for one unit). This encourages banks to retire their existing TruPS at a premium to where they trade in the secondary market.

The Fed began hiking rates in December 2015 and has now raised rates a total of six times during this cycle, with two more hikes expected in 2018. A secondary, unexpected driver of future cash flow improvements has been a greater-than-expected increase in LIBOR-OIS spreads, which widened from 10 bps in late 2017 to nearly 60 bps in March 2018. We believe this unusual phenomenon was driven by technical factors associated primarily with the repatriation of profits due to tax reform and a general unwillingness for overseas banks to tap the Fed’s dollar swap lines.

3.     Improving cash flows due to lower future deferred interest payments and potential windfalls from cumulative deferred interest payments. Banks that issue TruPS can defer interest payments on the instrument for up to five years before they risk triggering a default and liquidation by the FDIC. Many smaller banks took advantage of this feature, with the blessing of regulators, to shore up capital positions until their post-crisis fortunes improved. After five years, however, the banks need to pay all of the deferred interest or risk liquidation. Many TruPS-issuing banks are still on the hook for these payments, which could drive future TruPS CDO cash flow improvements. The underlying banks do have the option to pay cumulative deferred interest and then defer future payments again for the next five years. However, as long as interest payments are deferred, the bank cannot pay dividends to ordinary shareholders.

4.     Regulatory relief and pro-growth economic policies. We believe tax reform will help corporations and banks continue to shore up their balance sheets and return capital to shareholders and bondholders. Additionally, tax cuts should help the U.S. consumer and housing markets maintain their health and momentum. All of those factors should be positive for Financials via TruPS CDOs. We believe recent regulatory changes could benefit the theme in a number of ways (more on that below).

SkyBridge Partner and Senior Portfolio Manager Troy Gayeski discussed the our thesis for TruPS CDOs in-depth in the most recent edition of our SkyBridge Views video series.

Risks

We believe the biggest risk to our portfolio would be a surprise near-term recession, which we deem unlikely at this stage. A recession could lead to deteriorating bank credit quality, Fed rate cuts, mark-to-market losses, and, potentially, realized losses driven by lower cash flows. In such a scenario, underlying banks could also ?defer coupon payments on the TruPS.

Bank Regulatory Relief

The new bank regulatory relief law could be accretive to our Financials via TruPS CDO theme in at least two principal ways:

1.     Raising the asset threshold for systemically important financial institutions (“SIFI”) immediately from $50 billion to $100 billion and then to $250 billion in 18 months. This change will reduce compliance costs for regional banks, allowing them to return additional capital to shareholders and debtholders. It could also catalyze M&A within the sector, which would likely lead banks to retire more costly and less efficient legacy debt securities like TruPS at premiums to the current secondary market prices.

2.     Raising the Small Bank Holding Company (“SBHC”) asset threshold from $1 billion to $3 billion. Not only will this change reduce the regulatory burden on more than 300 small banks, but it will allow them to count less expensive and more efficient fixed-rate subordinated debt as Tier I capital. As a result, these community banks could look to retire more costly and less efficient legacy debt securities like TruPS at premiums to the current secondary market prices.

Big Picture

SkyBridge’s allocation to the Financials via TruPS CDOs theme, via its Relative Value Credit sub-strategy, is an example of how we provide access to non-correlated strategies and return streams that are not typically found in traditional portfolios and that cannot typically be replicated outside of hedge fund structures (e.g. mutual funds and ETFs, including smart beta and daily liquid alternative products). We believe alternative sources of return should prove increasingly important to portfolio diversification going forward given the current environment of rich equity valuations and low yields/tight spreads in traditional fixed income markets combined with tightening U.S. monetary policy.

Please feel free to contact us for more information: https://www.skybridgecapital.com/contact-form/

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