With the statements and actions of the Fed and Treasury continuing to show favoritism toward maintaining the solvency of financial institutions through common or preferred stock, I have been assembling data on trust preferred issuances. As subordinated debt, trust preferred securities stand to benefit greatly from any type of equity purchase by the Treasury – and since I started working on this a week ago, spreads have tightened as most of these have run by a double-digit (or more) amount.

Consider where the typical trust preferreds from these banks are trading relative to a dollar of par value, and the yield to maturity offered (assuming the obligations are money good):

Citigroup continues to offer a noticeably large risk premium over others, and despite its reputation as one of the “four that will not (be allowed to) fail,” the market is suspicious of investing senior to the government’s existing stake.

Of the above, I decided to focus on a handful of the companies to see if what value, if any, existed in purchasing their trust preferreds. The banks focused on, and their valuation multiple to pre-tax pre-provision profit (trailing four quarters) are below:

Pre-tax pre-provision profit includes net interest income, as well as fee-based income net of operating expenses. In addition to being a relatively stable metric, it is useful because it allows a comparison across banks of the charge-offs and loss provisions that can be taken before the bank starts to lose money.

Another issue is what kind of return the banks earn on their asset base. Earning a spread over assets is hard; boosting ROE through additional leverage is easier. The banks here that are not Citi or BoA are earning a run-rate pre-tax pre-provision profit of 2.5% or higher.

While ROE can be a tough comp because of differing leverage, a solid tangible equity base is crucial for absorbing charge-offs – and the ability to quickly grow tangible equity is a huge plus. Run-rate pre-tax pre-provision ROE (tangible) is a much more variable metric, but note that excluding Citigroup, the banks fall into a range around 40% to 60%.

Having looked at the loss allowances, non-performing asset ratios, and charge-offs, I am partial to US Bancorp – with higher reserves and better asset quality, it seems to have a more conservative book of business than a comparable large regional like BB&T. Given that public policy has effectively subsidized bank debtholders, the risk/reward trade-off for the securities most levered to such actions is intriguing, to say the least. Nonetheless, with the recent rally across these issues, yield to maturity has fallen below my desired threshold, and I will be looking elsewhere unless and until these pull back to offer more reasonable expected returns.

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