If you plan to invest client assets in preferred stocks, be sure to put on your financial analyst's hat.

The preferred stock market is going through a major change. The banking system is in repair mode, and we are at the bottom of the interest rate cycle. Preferred stock values drop when interest rates rise. And in April, Moody's downgraded two banks and warned 15 others they are in danger of a downgrade because their balance sheets are loaded up with a dangerous level of debt. More than half of all preferred stocks are issued by banks. Eighty-five percent of all preferred stock is issued by financial companies.

Adam Kramer, co-manager of the Fidelity Strategic Dividend and Income Fund, says that 40% of the preferred stock market could disappear by 2015 because of new government regulations to shore up the banking system.

Under the Dodd-Frank act, as well as the international Basel III agreement, banks must terminate trust preferred stocks starting in 2013 and have them off the books by 2015. Trust preferred securities were considered in calculating Tier 1 bank capital by the regulators. Tier 1 capital is a measure of financial strength. It consists of common stocks, disclosed reserves, retained earnings and nonredeemable noncumulative preferred stocks.

Trust preferred stocks are hybrid securities, primarily issued by bank holding companies since 1993. Ranked lower in a liquidation proceeding than senior and subordinated debt, but higher than preferred stock, they became an attractive way for bank holding companies to boost reserves. Reason: They were considered "Tier 1 capital" by regulators-a measure of financial strength-and thus helped banks meet expansion goals. 

Besides cumulative trust preferred stocks, Tier 1 capital consisted of common stocks, disclosed reserves and retained earnings. With trust preferred stock arrangements, bank holding companies issued preferred stock through trusts, which then loaned the proceeds to the bank. The trust passes the loan interest to preferred stockholders in lieu of stock dividends.

Bankruptcy rules generally prohibit preferred stockholders of the trust from initiating bankruptcy.

Nevertheless, these arrangements gave the bank the best of both worlds. Because the IRS considers the loan a bank debt, the bank needn't pay corporate taxes on interest payments. Plus, the bank could temporarily stop paying dividends. Banks, however, were on the hook for the debt and possible accrued dividend payments. So Uncle Sam ordered them phased out and completely off the books by 2015.

By year-end 2008, more than 1,400 bank holding companies had $150 billion outstanding in trust preferred stock, according to a report by the Philadelphia Federal Reserve Bank. "New regulations put in place in the wake of the 2008 financial crisis may make thorough analysis more important than ever," Kramer says. "A wave of preferred stock redemptions by banks could take place as new rules impact trust preferred stock. That is why it is important to pay attention to what type of security it is, where it is in the capital structure and the price at which it trades."

Greg Phelps, lead manager of John Hancock's four closed-end preferred stock funds, says the change isn't going to detract from the appeal of preferred stocks for income. Banks are calling in their higher-yield trust preferred stocks and issuing lower-yielding tax-advantaged preferred stocks. Tax-advantaged preferred stock does qualify as a Tier 1 asset.

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