Bank of America 'Best Positioned' for Trust Preferred Switch

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NEW YORK ( TheStreet) -- A bitter pill for investors could be a nice earnings boost for for Bank of America.

As required by the Dodd-Frank legislation, the Federal Reserve in June proposed enhanced capital requirements for large banks that exclude most trust preferred shares from regulatory Tier 1 capital. Since this is considered a "capital treatment event," banks have been redeeming their trust preferred shares, even before the call date, often at face value, despite any premium the market previously placed on trust preferred shares paying high dividends.

Regional banks have been quick to redeem the trust preferred shares this year, even though the proposed capital rules phase out the inclusion of most trust preferred equity from Tier 1 capital over a four-year period. Several regionals, including BB&T (BBT) and U.S. Bancorp (USB) , have moved aggressively to redeem their trust preferred shares, while taking advantage of the historically low rate environment to issue lower-paying non-cumulative perpetual preferred shares, which can be included as Tier 1 capital under the new rules.

While it's obvious that the new capital rules are squeezing investors, it's not a complete win for the banks. The banks are indeed getting a wonderful short-term benefit in being able to redeem the trust preferred shares -- even the ones that hadn't reached their call dates -- without paying a market premium, but the increased capital ratios required under the new rules mean that most of the large banks will pay more in dividends on newly issued preferred shares than the interest they are saving on the redeemed trust preferred shares.

This will happen because the new capital ratio requirements are so much higher than the old ones, and the large banks will all look to have preferred shares making up 150 basis points of their Tier 1 capital ratios, since this is the limit under the proposed rules, and the banks prefer to reach this limit, rather than hold additional common equity.

JPMorgan analyst Vivek Juneja on Tuesday said that "on a pro forma fully phased in basis, to account for full TruPS redemption and likely Preferred issuance (including what has been done to date in 2012)," Bank of America (JPM) "America would likely be the only bank with a net EPS benefit in our universe."

Juneja also said that on a fully phased in basis, with all trust preferred shares being redeemed and required perpetual preferred shares being issued to more than make up the difference, Regions Financial (RF) , SunTrust (STI) and Citigroup (C) , "would see higher EPS hit than peers."

Among large regionals, Juneja expects PNC Financial Services Group (PNC) to complete the redemption of all of its trust preferred shares before the end of the year.

Juneja said that "large cap banks have redeemed or announced plans to redeem $38 bil in TruPS in 2012, with interest costs averaging 6.7% - well above deposit and long-term debt rates," and that the redemptions of trust preferred shares have helped net interest margins "hold up better than feared by reducing funding costs to offset some of the decline in asset yields." But trust preferreds that have not yet been called "can no longer be called due to regulatory change - securities will need to reach their call date in order to be eligible to be redeemed," and others "may not be called near term because they are floating rate or hedged and provide attractive low cost long-term debt funding," according to the analyst.