Capital Trust Securities

Capital trust securities (also known as trust capital securities) are a type of investment sold to investors by a specifically created trust established and controlled by a financial institution (i.e. banks or other financial intermediaries). They are trust-originated securities that combine the features of both preferred shares and corporate bonds.

Example:  Let’s say XYZ Bank wants to create a new series of capital trust securities. It would have to go about doing that using a process something like this:

  • XYZ Bank creates a trust entity – XYZ Trust.
  • The Bank owns and controls the trust by retaining all of the voting securities of the trust (the voting securities of the XYZ Trust).
  • XYZ Trust then sells XYX Capital Trust Securities to investors and the trust receives cash payment from the investors.
  • XYZ Trust then uses its cash to purchases assets from XYZ Bank to hold within the trust.
  • The income earned by the trust assets is then paid to the investors that purchased the XYZ Capital Trust Securities.

The capital trust securities are simply units of a closed-end trust and are typically traded and priced the same as corporate bonds (sold in $1,000 increments and priced with reference to a $100.00 par value). This is because capital trust characteristics are closely aligned with those of a corporate bond and the credit rating agencies assess their credit strength according the scale used for bonds, with the AAA rating representing the highest quality.

Even though capital trust securities rank equally with preferred shares, in the event of financial default or bankruptcy, distributions are made semi-annually and are classified as interest payments for the trust and interest income to the investor. There is no dividend income tax credit for the investor.

The assets sold to the trust by the creating financial institution can vary but typically the assets consist of Residential Mortgages, Mortgage Co-ownership Securities, or various other debt obligations. The capital trust’s assets are typically purchased from and serviced by the issuing financial institution.

Understanding why financial institutions use trusts and sell capital trust securities

In Canada, The Office of the Superintendent of Financial Institutions (OFSI) regulates financial institutions. The OFSI, established in 1987 under the OFSI Act,

…. is a federal government agency that is “responsible for regulating and supervising all banks in Canada and all federally incorporated or registered trust and loan companies, cooperative credit associations, life insurance companies, fraternal benefit societies, and property and casualty insurance companies. It also regulates and supervises federally regulated private (employer-sponsored) pension plans that are subject to the Pension Benefits Standards Act, 1985. Through the Office of the Chief Actuary, OSFI provides a range of actuarial services, under legislation, to the Canada Pension Plan (CPP) and some federal government departments, including the provision of expert and timely advice in the form of reports tabled in Parliament.

Under Canadian and international standards, financial institutions are required to maintain certain minimum levels of Tier 1 and Tier 2 capital. Tier 1 capital is the financial institution’s core capital and generally includes common shareholders’ equity, qualifying non-cumulative perpetual preferred shares, and qualifying innovative capital securities, such as capital trust securities. Tier 2 capital is the financial institution’s supplementary capital which generally consists of less permanent capital structures like subordinated debt and bonds.

For example, Canadian banks are required by the OSFI to maintain certain minimum Tier 1 and Tier 2 capital ratios, expressed as a percentage. The ratios, one for Tier 1 and another for Tier 2 capital, are calculated by dividing the total capital held in either Tier by the bank’s total Risk-Weighted Assets.

So if a bank wishes to increase the amount of its Risk-Weighted Assets (mortgages, line-of-credits, credit cards, business loans, etc.), it will have to set aside a proportional amount of Tier 1 or Tier 2 capital in order to maintain the OFSI set minimums. By issuing a subordinate bond the financial institution will increase its total capital, but not its Tier 1 capital level, as subordinate bonds do not qualify as Tier 1 capital. Therefore, if the institution wishes to increase the amount of Risk-Weighted Assets, they must also issue additional amounts of common shares; non-cumulative perpetual preferred shares or innovative securities like capital trust securities.

For example, if a bank were to simply issue additional mortgages this would negatively impact its Tier 1 capital ratio, which would not be perceived positively by the OSFI and stock market investors. But if they issued additional mortgages and, at the same time, sold those mortgages to a newly created capital trust, their Tier 1 capital ratio would actually improve. This is because the newly issued mortgages would not increase the bank’s Risk-Weighted Assets because they would be owned and held by the capital trust and the bank’s Tier 1 capital would increase because the capital trust securities are classified as Tier 1 capital.

Example: Let’s assume that XYZ Bank currently has $8.0 million of Tier 1 capital and total Risk-Weighted Assets of $100 million. This would translate into an 8% Tier 1 capital ratio for XYZ Bank.

Now let’s assume the XYZ Bank issues a subordinate bond and raises $10.0 million, which it uses to fund new mortgages for its clients. Because the subordinate bond does not qualify as Tier 1 capital, XYZ Bank’s Tier 1 capital remains at $8.0 million. By issuing the $10.0 million of new mortgages, XYZ Bank’s Risk-Weighted Assets have increased to $110 million and their Tier 1 capital ratio has now declined to 7.27% ($8.0 divided by $110).

But if the bank were to actually issue the $10 million in new mortgages, establish an XYZ Trust, wholly owned by XYZ Bank, to sell capital trust securities and purchase the $10 million of new mortgages, the bank’s Tier 11 capital ratio would improve. This is because the $10 million of new mortgages would technically be owned and held by XYZ Trust so XYZ Bank’s Risk-Weighted Assets would not increase. In addition, XYZ Bank would have issued $10 million of capital trust securities that qualify to be included in the bank’s Tier 1 capital. The net impact is that XYZ Bank’s Tier 1 capital ratio would now improve to 18% ($8.0 +$10.0 divided by $100).

As the Dominion Bond Rating Service (DBRS) stated in its July 5, 2007 Commentary Hybrid Capital, Ratings and Equity Credit, “By issuing hybrids, banks can preserve and boost their regulatory capital while avoiding dilution for existing shareholders… If regulatory acceptance did not exist, bank hybrid securities, in their current form, would not be issued.”

Remember: Capital trust securities offer financial institutions a cost effective method of raising tax-deductible Tier 1 capital without issuing higher cost and diluting preferred or common shares with their non-tax deductible dividend payments. And investors are attracted to capital trust securities due to their typically higher coupon rates and the attractiveness of the issuing institution’s credit quality.

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