Did A TPS Report Cause The Shift To Tangible Common Equity?

The Treasury’s focus on tangible common equity (TCE) is not a coincidence, it is a necessity. One of my favorite movies is Office Space, my wife usually goes to another room when I watch it, but there is something about the quirky truth of office life that simply cracks me up. That is why when I saw the Philadelphia Federal Reserve Quarterly Regulator Report had published an article about TPS I thought I was in for a good chuckle. Sadly I was not.

The TPS they refer to are Trust Preferred Securities, a hybrid security that virtually every bank has issued and is included in Tier 1 capital. The nifty thing about these securities is the banks can deduct the interest/dividends payments for tax purposes and not dilute common shareholders. In 1996, the Federal Reserve approved these securities as part of Tier 1 capital with certain limitations. Within 1 year, over 100 bank holding companies had issued TPS and by 1999 110 banks issued TPS valued at $31.0b. According to the Federal Reserve, TPS issuance exploded over the next few years and as of December 31, 2008 1400 bank holding companies had $148.8b in outstanding TPS.

In 2005, the Federal Reserve issued a final ruling on the limitations on including TPS in Tier 1 capital. For “internationally active” banks no more than 15% of restricted core capital can be comprised of TPS. For purposes of regulation any bank that has consolidated $250b in assets is considered “internationally active” regardless of where they operate. The new rule requires that goodwill less and deferred tax liability be deducted from capital. Thankfully, the Federal Reserve gave the banks a few years to comply with this new rule.

Removing goodwill from the calculation will have a significant impact on the amount of TPS allowed in Tier 1 capital. Unfortunately, during times of economic weakness, core capital decreases and as core capital decreases the amount of TPS allowed as capital decreases. Which will likely lead to financial stress for the bank and will further impair capital, which will require further reductions in TPS included in capital. Sick yet? You should be, it is another downward spiral.

The two major banks under recent scrutiny (Citibank (C) and Bank of America (BAC)) recently filed their annual reports and disclosed how close they are to the 15% limit on TPS. Citibank is at 11.8%, while Bank of America is at 14.7%. Citibank has already written down goodwill, but Bank of America has not.

In the footnotes to the Bank of America annual report there was this little gem of a statement regarding goodwill…

The annual impairment test as of June 30, 2008 indicated some stress in certain reporting units. Given the significant decline in our stock price and current market conditions in the financial services industry, we concluded that circumstances warranted an additional impairment analysis in the fourth quarter of 2008.

The impairment analysis is a two step process. In doing the analysis, Bank of America found that the MHEIS business failed the first step. However, all businesses passed the second step of the analysis…good news…except for the disclaimer..

If current economic conditions continue to deteriorate or other events adversely impact the business models and related assumptions used to value these reporting units, there could be a change in the valuation of our goodwill and intangible assets when we conduct impairment tests in future periods and may possibly result in the recognition of impairment losses.

Of course a goodwill impairment is not necessarily a capital impairment. However, something caused the impairment and it will ultimately impact capital. Since Bank of America is very close to the 15% threshold it would take a capital impairment of only $2.5 billion to push them over the edge. Compared to Citi’s $9.6b impairment charge, $2.5b is pocket change. From this perspective it’s clear why the Treasury’s focus is now on tangible common equity not Tier 1.

When do the banks have until to comply with the rule change? March 31, 2009. Enjoy March Madness!

Dislcosure: I have no positions in C or BAC.

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