Financial innovations and excesses revisited: the case of auction rate preferred stock - Security Design Special Issue

Financial Management (Financial Management Association), Summer, 1993 by Michael J. Alderson, Donald R. Fraser

Perhaps most importantly, the reform bill dramatically increased the capital requirements at thrifts by requiring them to meet the same capital requirements as FDIC insured banks by June 1, 1991 (six percent as compared to a previous loosely enforced standard of three percent).(14) For most thrifts, with little or no earnings, and unable to access the capital market for equity, shrinking total assets was the only feasible way to meet the new capital requirements and the sale of the mortgage-backed securities in the limited-purpose subsidiaries (and the redemption of the auction rate preferred issued by these subsidiaries) became the most practical way to shrink. At the same time, since the thrift reform legislation abolished the existing thrift regulator (the Federal Home Loan Bank Board) and replaced it with a new (and tougher) regulator (the Office of Thrift Supervision), there was some concern about the continued existence of the "corporate veil" at these limited-purpose subsidiaries, referred to as "regulatory call" risk.(15)

The Revenue Reconciliation Act of 1990 also reduced the attractiveness of special-purpose subsidiary financing by imposing limitations on the consolidation of parent net operating losses to offset income earned on the investment of auction rate preferred proceeds. Because these limitations apply to auction rate preferred stock issued after November 17, 1989, they serve to limit the tax arbitrage opportunities available from selling new bankruptcy-remote issues.

2. Bank Capital Requirements

Changing capital requirements in the banking industry may also have played a role in the redemption decision of banking organizations. On December 29, 1989, the Federal Reserve Board issued for public comment a proposal to limit the proportion of perpetual preferred stock to 25% of Tier I capital.(16) This proposal was subsequently adopted (along with the other component of risk-based capital) late in 1990.

Dividend yields on auction rate preferreds in the banking sector rose dramatically during late 1990 in apparent response to weak industry earnings. We hypothesize that the change in Tier 1 capital requirements reduced the nontax benefits of employing auction rate preferred as a source of capital, thus exacerbating the incentive to redeem issues within the banking sector in favor of issuing lower cost securities.(17)

C. Other Factors

Van Horne |11~ defines a legitimate financial innovation as a security which makes the financial markets more efficient and/or more complete. In his analysis of financial innovation and excesses, he attributes the development of adjustable rate preferreds to both tax law changes and to a demand for products that reduce the risk associated with volatile interest rates, and observes that:

The various devices recently conceived and sold as financial innovations are not bubbles, although some of the same excesses are present ... A balloon might be a better metaphor for certain financial promotions. It is blown up to be sure, but not to the extent that it pops. The eventual deflation is less abrupt.