The trust preferred CDO market: from start to (expected) finish

This paper investigates the development, issuance, structuring, and expected performance of the trust preferred securities collateralized debt obligation (TruPS CDO) market. Developed as a way to provide capital markets access to smaller banks, thrifts, insurance companies, and real estate investment trusts (REITs) by pooling the issuance of TruPS into marketable CDOs, the market grew to $60 billion of issuance from its inception in 2000 through its abrupt halt in 2007. As evidenced by rating agency downgrades, current performance, and estimates from the authors' own model, TruPS CDOs are likely to perform poorly. Using data and valuation software from the leading provider of such information, they estimate that large numbers of the subordinated bonds and some senior bonds will be either fully or partially written down, even if no further defaults occur going forward. The primary reason for these losses is that the underlying collateral of TruPS CDOs is small, unrated banks whose primary asset is commercial real estate (CRE). During their years of greatest issuance from 2003 to 2007, the booming real estate market and record low number of bank failures masked the underlying risks that are now manifest. Another reason for the poor performance of bank TruPS CDOs is that smaller banks became a primary investor in the mezzanine tranches of bank TruPS CDOs, something that is also complicating regulators' resolutions of failed banks. To understand how this came about, the authors explore in detail the symbiotic relationship between dealers and rating agencies and how they modeled and sold TruPS CDOs. In their concluding comments, the authors provide several lessons learned for policymakers, regulators, and market participants.