Capital Alternatives in Today’s Distressed Environment

By Paul D. Reese, CFA, Managing Director
Howe Barnes Hoefer & Arnett

Holy Cow! It is not enough to just date this article—I guess I need to time stamp it as well just to keep up with the rapid developments in the capital markets! For the record, it is 12:00 p.m. Pacific Time on Tuesday, October 14, 2008. The body of this article was written after the U.S. markets closed on Friday, October 10, in the aftermath of the most volatile trading session in the history of the organized exchanges—and a week in which the Dow Jones Industrial Average lost over 18% of its value. Obviously, my friends, it is the most interesting and turbulent of times we are in, which bring with them calls for potential global depressions and financial meltdowns on one day and, perhaps, a potential for stabilization and a capitulation in the global credit crises the next. The global credit markets are still experiencing unprecedented seizures, but the coordinated actions of the governments of the civilized world may be beginning to unlock the credit markets, particularly in Europe, which has, in my estimation, experienced significantly greater credit seizures than here in the U.S.

On October 9, Iceland was forced to nationalize the last of its three major banks, and without foreign aid, the country is still likely to default. On October 3, the government of Belgium took over Dutch banking and insurance giant Fortis SA/NU and, subsequently, sold the majority of Fortis to BNP Paribas Group of France in an assisted transaction. On October 8, Britain announced a £50 billion ($87.7 billion) recapitalization plan in conjunction with a £200 billion ($350.8 billion) short-term lending facility. The British government is also providing a government guarantee on new short- and medium-term bank debt in an attempt to provide stabilization in the British banking sector. The British financial system has experienced significant dynamic shocks from the failures of Northern Rock and Bradford & Bingley, the distressed sale of HBOS PLC to Lloyds, and the almost 40% plummeting of Royal Bank of Scotland’s shares on October 7 amid concerns of a potential collapse. Also on October 8, central banks around the world announced a coordinated interest rate cut, and countries throughout the European Union increased or offered blanket bank deposit protection to facilitate a potential stabilization. As fear grips the global credit markets, overnight USD LIBOR spreads have increased from five basis points over the Fed funds rate on July 2, 2007, to 369 basis points as of October 9. Over the same period, three-month LIBOR has increased from 41 basis points over the three-month, constant maturity T-Bill, to 415 basis points as of October 9.

After an emergency meeting in Paris on Sunday, October 13, six member states of the European Economic Community, which utilize the Euro, and Britain announced a massive coordinated response to the spreading global credit crises, pledging country-specific, bank capital infusions and government debt guarantees of up to $2.3 trillion in aggregate. In addition, Britain announced up to a $63 billon investment of preferred and common equity in Royal Bank of Scotland and Lloyds, giving the British taxpayers a significant stake in both institutions. As a response to these announcements, on Monday October 13, stock markets around the world experienced double-digit percentage gains and the U.S. markets experienced the largest one-day point gain ever.

Here in the U.S., we have seen the collapse and sale of Countrywide Financial Corp, the failures of both IndyMac Bancorp and Lehman Brothers, and the facilitated sales of Bear Sterns, Washington Mutual, and Wachovia Corporation. We have also witnessed the multibillion dollar defacto nationalizations of Fannie Mae, Freddie Mac, and insurance giant AIG, as asset quality issues and liquidity and capital pressures continue to converge, creating an atmosphere of fear and insolvency. In addition, the depressed sale of Merrill Lynch to Bank of America and the conversion of Morgan Stanley and Goldman Sachs to bank holding companies demonstrate the lack of liquidity and non-core funding available within the financial services sector. As a response to these events, the Federal Reserve created the Term Auction Facility and has provided unprecedented utilization and expansion of the Discount Window—and established the Commercial Paper Funding Facility. Nevertheless, there is certainly evidence this credit squeeze is continuing to spread rapidly throughout global nonbank sectors.

The following graph depicts financial institution performance compared to the overall markets since the beginning of the crises.

Relative Index Performance

Source: SNL Financial LC
Dates Graphed: 6/8/07 - 10/10/08

It is interesting to note that despite the 22% decline in the Dow Jones Industrial Average and the 21% decline in the NASDAQ Composite index between September 30, 2008, and October 10, 2008, the SNL Bank Index has still not retested the low it hit on July 15 upon the failure of IndyMac. While certainly these are dark and perhaps even horrific times, I will say that, although we are all getting battered and bloody and many more community banks will certainly fail, this is also a tremendously healthy correction that will ultimately benefit the community banking sector.

In my estimation, competitive forces coupled with the vast securitization and commodization of financial products resulted in risk being priced out of both sides of the balance sheet. While the general public is scared, and we have all fielded questions regarding the safety of our customers’ deposits, both core customers and their deposits remain extremely sticky in all but the direst of situations, and it has once again become glaringly obvious that we are the only industry in the entire world where our greatest assets are our liabilities. Cheap core deposits drive the viability and sustainability of our industry. I believe the community banking industry that survives these tumultuous times will, and in fact already is beginning to see a significant inflow of high quality customers, significantly higher risk-adjusted loan yields, better guarantees, and lower deposit costs. The significant deposit pricing pressure brought on by the dire liquidity needs of faltering institutions has begun and will continue to subside as these institutions are acquired or fail. While the subprime mortgage market coupled with irrational loan pricing and originations, facilitated by securitization vehicles and abundant inexpensive foreign and domestic capital, created the real estate bubble and the foundation of this crisis, the exposure of the community banking industry to these asset classes has proven insignificant from a systemic perspective. However, the obvious carry over into the residential construction and development space has and will continue to create tremendous strain on community bank loan loss reserves and capital levels.

On October 10, the U.S. Treasury confirmed plans, under broad powers granted in the “Emergency Economic Stabilization Act of 2008,” to make direct capital investments into financial institutions in conjunction with other far-reaching coordinated steps “to encourage the raising of new private capital to complement public capital.” Against this backdrop, it has become blatantly obvious that capital is king. The good news is that private capital is out there and available across the banking sector in all but the most dire of situations. On September 22, the Board of Governors of the Federal Reserve introduced the relaxation of equity investments in banks and bank holding companies under the Bank Holding Company Act. The revised interpretation allows for minority interest investments in banks of up to 15% of voting securities and 33.3% of total equity investment, as well as up to 25% board representation, without registering as a bank holding company. This modification has already begun to help facilitate private equity investments in the banking sector.

On October 14, the U.S. Treasury announced sweeping new initiatives to ease the destabilizing three-headed demon of credit, capital, and liquidity. The initiatives include the “TARP Capital Purchase Program,” under which the Treasury will purchase up to $250 billion in senior preferred shares from qualifying financial institutions. These redeemable preferred shares will count as tier 1 regulatory capital and carry an initial interest rate of 5.0% over the first five years and subsequently increase to 9.0% thereafter. The senior preferred is redeemable at any time by the issuing institution if a minimum of 25% is replaced by newly issued common or preferred shares. In addition, the senior preferred shares may be redeemed in whole or in part at any time after three years. Dividends are cumulative if the issuing institution is a registered bank holding company; if there is no holding company, dividends are non-cumulative. To participate in the program, a qualifying institution may subscribe for no less than 1% of its risk-weighted assets and no more than the lesser of $25 billion or 3.0% of risk weighted assets. As part of the purchase, the Treasury will receive 10-year warrants with an aggregate purchase price of 15% of the senior preferred issued. The initial warrant strike price, which is subject to potential adjustment, will equal the trailing average, 20-trading-day closing price of the issuing institution’s common shares prior to funding. Eligibility for the program and funding allocations will be made by the Treasury on a case-by-case basis, based on consultations with the appropriate regulatory agency. Participating institutions must also comply with the executive compensation rules under the Emergency Economic Stabilization Act. Nine large U.S. financial institutions have indicated total subscriptions in the facility of $125 billion. Applications for the program must be made by November 14, 2008. Secondly, under the The Temporary Liquidity Guarantee Program, the FDIC will guarantee the senior unsecured debt of all FDIC-insured institutions and their holding companies, as well as guarantee all non-interest bearing deposit transaction accounts. The deposit guarantee is extremely significant and will assist the industry in maintaining primary business account deposit relationships. In addition, as noted below, the guarantee of bank holding company loans is of paramount importance to small bank holding companies, allowing more cost-effective access to regulatory capital. Finally, beginning October 27, 2008, the Commercial Paper Funding Facility will begin purchasing three-month maturity, high-quality commercial paper across all business sectors.

As the chart below demonstrates, there are numerous other private sector forms of capital and structures available in the marketplace. Particular circumstances will dictate which form or forms and in what amounts are right for each institution.

Summary of Capital Alternatives

While capital is certainly available for the vast majority of institutions, it is critical to make the right decisions regarding the type(s) and amount(s) of capital to seek. Unlike the freely flowing and attractively priced capital markets experienced in our industry from approximately 2003 to the beginning of the current crises in August 2007, today’s private-sector capital marketplace is challenging and expensive. Prior to the demise of the pooled trust-preferred markets in August 2007, these securities were being offered at rates as low as 135 basis points over three-month LIBOR. Today, this market no longer exists, and single–issuer, publicly traded, trust-preferred securities are pricing at 9% or more, even for the healthiest of institutions. The following table demonstrates current expected costs associated with the spectrum of capital alternatives. Again it should be noted that, unlike the relatively homogenous pricing for product types seen prior to the beginning of the crisis in August 2007, in today’s volatile marketplace, costs associated with any particular instrument vary widely based on the market’s current perception of company specific and systematic risk.

Capital Formation—Cost of Capital Considerations

(1) Bank level only
(2) Includes cost of coupon plus issuance of equity at a premium to market

Despite depressed stock prices and the increased funding costs associated with all forms of capital in today’s market environment, we have seen more aggregate capital raised in the industry than ever before. Through October 10, 2008, banks and thrifts raised approximately $174.7 billion in total of new debt and equity capital.

2008 Bank and Thrift Capital Offerings

Source: SNL Financial LC
As of 10/06/08

The vast majority of this new capital has been raised to shore up regulatory capital positions in the face of continued loan loss reserve builds, significantly elevated charge-off levels, and other-than-temporary impairment charges on securities. Despite this significant capital build, regulatory concerns regarding capital levels continue to be voiced—particularly for those institutions with high concentrations in construction and development and commercial real estate credits. We have heard numerous stories throughout this regulatory examination cycle, where regulatory authorities are voicing serious concerns that regulatory capital levels need to be significantly augmented—even among institutions whose capital levels are well above those required to remain “well capitalized” under Prompt Corrective Action guidelines. In this environment, preservation and abundance of capital is key.

In terms of the nuances of the forms of available capital instruments, the following table outlines the general structure, advantages, and disadvantages of several forms of capital.

Capital Strategy Structure Advantage Disadvantage
Common Stock – Public Offering • Priced at either market or slight discount
• Marketed to both retail and institutional investors in a fully registered offering
• Timing is critical; offering is highly dependent on market conditions		 • 100% of proceeds qualify for Tier 1 capital
• Strongest form of capital for both rating and regulatory purposes
• Increases liquidity of issuer in the marketplace
• Combined with additional leverage, aggressive growth can be pursued without impairing capital ratios		 • Results in dilution of ownership to existing shareholders
• Market price of stock may experience downward pricing pressure during marketing period• Would incur the highest costs of issuance and greatest cost of capital to the issuer
• Dividend payments are not tax deductable
• Results in immediate increase in basic and diluted shares outstanding
Common Stock – Rights Offering • Rights are issued to existing shareholders to buy additional shares at a given price for a fixed period of time
• Rights may either be transferable or nontransferable
• Generally priced at a discount to market (8 to 10%)
• Shareholders have incentive to exercise rights or otherwise be diluted by issuance of new equity 		• Allows existing shareholders to participate in offering
• Probability of success is high due to strong insider and existing shareholder interest
• Sends the market a clear signal of insider confidence in the company and its prospects
• Offering costs are lower than a follow-on offering of common stock
• Attractive financing mechanism in times of dry financial markets 		• Discount to market may be greater than that of public offering
• Diversification of shareholder base is limited to new standby purchasers and purchasers of transferable rights (if included in the terms)
• Immediate increase in basic and diluted shares outstanding, resulting in dilution to earnings per share and book value per share (if issued at a discount to book value)
Convertible Preferred Stock • Usually offered in denominations of $50 or $100
• Generally includes a conversion premium of 0% to 25% depending on the length of time until possible conversion and company condition
• Dividends can either be cumulative or noncumulative
• Typically includes call protection of at least three years 		• Does not result in immediate ownership dilution to existing shareholders
• Allows issuer to raise “equity” capital at a higher valuation than what is currently available through a common offering
• Dividend payments are typically deferrable
• If dividends are noncumulative, entire offering proceeds would qualify for Tier 1 capital 		• Dividend payments are not tax deductable • “If converted,” accounting increases diluted share calculation • Once converted, it is immediately dilutive to current shareholders • Generally requires a liquid market for the underlying common stock to ensure a successful transaction • If dividends are cumulative, Tier 1 capital restrictions are the same as TPS without regulatory approval
Trust Preferred Securities (TPS) • Can be structured as either a public or private offering
• Pricing is generally at a fixed rate for 30 years
• Requires the formation of a subsidiary trust to issue securities
• Terms generally provide for a 30-year maturity and call protection for the first five years
• Distributions are deferrable for up to 20 consecutive quarters, provided the dividends on the parents common stock are suspended as well 		• No dilution to existing shareholders
• Distributions to investors are tax deductible by the parent of the issuing trust
• Qualifies for up to 25% of pro forma Tier 1 capital treatment
• An issuance at the holding company level can be pushed down to the bank level as equity—all of which will count toward Tier 1 capital 		• Beginning in 2009, changes to the calculation of Tier 1 capital regarding the treatment of intangible assets may reduce the allowable amount of TPS in Tier 1 capital for institutions with large amounts of goodwill
• Downstreaming the proceeds from the sale of TPS to the bank as equity can place pressure on the holding company’s double leverage ratio
• Typically, minimum profitability, asset quality, and capital levels are needed to issue
Subordinated Debt • Usually offered in denominations of $1,000 and sold institutionally
• Can be structured as either a private or public offering
• Typically issued at the bank subsidiary level
• Can be structured with either floating or fixed rate
• Call protection usually lasts for at least seven years
• Term of issue is usually 10 to 30 years 		• Does not result in ownership dilution to existing shareholders
• Interest payments are tax deductible
• Proceeds can be used as an equity capital contribution to a subsidiary and may, therefore, qualify as Tier 1 capital at the bank level
• Securities issued at the bank level are exempt form SEC registration; consequently the time and complexity to complete the offering is less than other financing options
• Issuance at the bank level generally results in a lower interest rate than issuance at the holding company level 		• Qualifies only as Tier 2 capital at the issuing entity level and is subject to certain restrictions
• Challenge of upstreaming funds for debt service requirements may create a capital management issue
• Stringent debt service requirements due to high interest rate
• Interest payments are not deferrable and, if not paid, would constitute an event of default
• Downstreaming the proceeds from the sale of subordinated debt to the bank as equity can place pressure on the holdings company’s double leverage ratio

There are a myriad of other hybrids of these instruments, which can be utilized based on company-specific circumstances. They include, but are certainly not limited to, pay-in-kind (PIC) features, conversion into other instruments or assets, imbedded interest rate steps, altering conversion prices based on performance covenants, floating-versus-fixed interest rates and conversion features, and call and put features. Alternatively, for bank holding companies with consolidated total assets under $500 million, correspondent bank debt is also a viable form of capital. Under the Small Bank Holding Company rules, the Federal Reserve does not hold institutions under $500 million to consolidated regulatory capital guidelines. This allows these institutions to significantly leverage the holding company with debt. As I mentioned previously, the FDIC’s new guarantee on holding company bank debt will probably make this the cheapest and most flexible capital available today.

The most important thing I can tell you is that capital is out there and available. However, in today’s environment, it is absolutely imperative that you explore all the various forms of capital and carefully weigh the advantages and disadvantages of each. The right form(s) and amount(s) of capital needed, as well as the cost of each, will be dictated by each company’s unique situation, as well as the public’s perception of the institution and geographic market in which it operates. Also, please remember that if you need capital or just think some cushion might help in today’s tumultuous market, you will probably only have one chance to raise it. The cost of a failed capital raise in this environment can very easily lead to the demise of an institution, facilitated by market and customer concerns causing a collapse in share prices and increasing stress on liquidity and the deposit base.

As a couple of side notes… In my estimation this is the most advantageous time since perhaps 1989 to undergo a full mutual to stock conversion, as we are certainly at pricing levels not seen since 1990. In addition, while merger and acquisition activity has almost come to a standstill, market headwinds coupled with the lack of historically active acquirers have created an environment where mergers of equals and strategic partnerships make a significant amount of sense. We are also seeing the emergence of a two-tiered valuation system in the public markets between the “haves” and “have nots.” As this phenomenon comes to full fruition, coupled with the recent revised guidance on market accounting under FAS 157 and the carveout for the utilization of net operating loss carry forward under Section 382 of the Tax Code, merger activity will increase dramatically as those institutions that have remained relatively healthy will be able to pay a significant premium over more troubled institutions’ current share prices.

As a final note, there is absolutely no doubt in my mind we will pull through this cycle despite what will probably be the most sweeping, regulatory bank and compliance reforms in history, as well as significantly increased regulatory and insurance assessment costs. In fact, I believe we will emerge from this crisis stronger than—and as profitable as—any time in the history of community banking.

For more information or to discuss your company’s specific needs and circumstances, please feel free to contact me at 415.538.5727 or at your convenience.

Sources utilized in this article include: the press room of the United States Department of the Treasury, the Board of Governors of the Federal Reserve Statistical Releases; press releases of the Federal Deposit Insurance Corporation; the European Central Bank press room; the news room of Her Majesty’s Treasury; the British Bankers Association press room and BBA historical LIBOR quotes; SNL Securities L.P.; Reuters; the Associated Press and; Bloomberg News.

About the Author
Paul Reese is a managing director with Howe Barnes Hoefer & Arnett on the firm’s investment banking side in San Francisco. He is a registered representative and principal with FINRA and holds the Chartered Financial Analyst (CFA) designation. His expertise includes: capital formation, mergers and acquisitions, valuation analysis, strategic planning, security and market analysis, financial forecasting, and de novo bank formations. Mr. Reese has represented more than 80 financial institutions in completed merger and acquisition transactions and conducted more than 1,000 valuation assignments over his nearly 15-year career in the financial institutions industry. Mr. Reese has counseled the boards and management of numerous financial institutions, while conducting strategic planning sessions and board retreats throughout the country. Mr. Reese educates financial institutions on ways to remain independent while enhancing shareholder value. Mr. Reese has also lectured on mergers and acquisitions and strategic planning at the LSU Graduate School of Banking, the BAI Graduate School of Banking, the Minnesota League of Savings and Community Bankers, the Iowa Community Bankers, and the National Association of Corporate Directors.

Paul D. Reese, CFA
Managing Director
Howe Barnes Hoefer & Arnett
555 Market Street
18th Floor
San Francisco, California 94105
Office: 415-538-5727
Email:

Established in 1915, Howe Barnes Hoefer & Arnett, Inc. is a full service brokerage firm headquartered in Chicago, Illinois, with offices in six states throughout the U.S. Through its bank sales and trading, research, investment banking, and asset finance services departments, Howe Barnes specializes in community banks and thrifts. Through its private client services department, the firm provides investment advice and products to both individual and institutional customers. Howe Barnes Hoefer & Arnett is the exclusive provider of capital markets services for the Independent Community Bankers of America (ICBA). The firm delivers fixed-income products and services through a strategic initiative with Vining Sparks IBG, Memphis, Tennessee. www.howebarnes.com