David R. Evanson
Present Value: Essays on Community Banking, Winter, 2005
When the Federal Reserve Bank ruled in 1996 that proceeds from the issuance of trust-preferred securities (TruPS) could account for up to 25 percent of tier-1 capital, the ruling had a materially positive and significant impact on investors and issuers alike.
According to the Federal Reserve Board, tier-1 capital consists of core elements of stockholders’ equity, including par value, additional paid-in-capital, and qualifying cumulative and noncumulative perpetual preferred stock, as well as minority interests in the equity accounts of consolidated subsidiaries.
Trust-preferred securities are subordinate to all debt on a company’s balance sheet but senior to preferred and common stock. Most TruPS have 30-year, nonamortizing terms and pay quarterly or semiannual interest. Circumstances permitting, many trust-preferred issues may defer interest for up to five years and have a call feature, which often starts at five years for smaller institutions and 10 years for larger ones.
The benefits of including trust-preferred securities in tier-1 capital for depository institutions are manifold. First, it enables banks to access capital to fuel growth -– organic or from acquisitions -– that is nondilutive. 5Second, capital in the form of trust-preferred securities is inexpensive. Trust-preferred securities are typically priced at LIBOR plus 1.5 percent to LIBOR plus 3 percent, depending on collateral. This coupon is dramatically less expensive than the required return on equity for banking institutions, which currently ranges from 12 percent to 15 percent, depending on the size of the institution. Third, trust-preferred securities offer banks a tax-efficient form of capital since interest payments are fully deductible, while preferred dividends are not.
For several years after the Federal Reserve granted tier-1 relief on trust-preferred securities, they remained chiefly the province of larger banks. These institutions could gain economies of scale, lower their overall issuance costs, and offer enough securities to develop an adequate secondary market that would offer investors liquidity in addition to yield. While in theory the benefits of trust-preferred securities were available to all depository institutions, in practice the required size of trust-preferred issuances kept them out of the reach of smaller institutions.
In 2000, four years after the Federal Reserve granted tier-1 capital relief, an innovative structure was developed that enabled smaller community and regional banks to capitalize on the demand for trust-preferred securities among investors. Specifically, this breakthrough was the issuance of trust-preferred securities from several institutions, which were then pooled into a collateralized debt obligation, or CDO.
Thus the TruPS CDO market was born. Since 2000, more than $20 billion of new issues have come to the market, making TruPS CDOs one of the largest new-issue segments in the CDO subsector in the United States. The rapid rise of the TruPS CDO is equally attributable to demand as well as supply influences.
The features affecting demand will be covered later in this chapter, along with regulatory influences, which play a role as well. Once they were made available to small community banks, TruPS were readily embraced due to modest issuance costs, absence of dilution and tax efficiency.
To remove the abstraction of these benefits, consider the following real examples of how U.S. regional banks used TruPS to drive growth in a way that was unthinkable just five years ago.
Product Expansion: First Community Bancorp (NASDAQ: FCBP) in Rancho Santa Fe, Calif., is a bank holding company with approximately $2.7 billion in assets across two wholly-owned subsidiaries, Pacific Western National and First National Bank. Through its 32 full-service community banking branches, First Community provides commercial banking services, including real estate, construction and commercial loans, to small and medium-sized businesses.
As 2003 came to a close, the bank’s senior management wanted to expand First Community’s commercial lending business and felt a commercial finance company would round out the bank’s product offering. In February 2004 First Community announced an all-cash, $40 million deal to acquire First Community Financial Corp. (FC Financial), a commercial finance company headquartered in Phoenix, Ariz., with whom it had a longstanding business relationship.
The acquisition would extend FCBP’s core lending products with higher-margin products and diversify its existing portfolio by increasing the commercial and industrial lending base. Additionally, because of FC Financialzzs historical success managing credit quality, the acquisition would provide additional risk-management expertise for FCBP’s current portfolio.
Operationally, the fit was good. A $60 million issuance of trust-preferred securities, which was part of a larger TruPS CDO, to finance the FC acquisition along with the acquisition of Harbor National Bank, helped make the transaction more financially viable and less expensive for First Community’s existing shareholders.
At the time the transaction was announced, First Community common stock was trading at $38.35. With 15.4 million shares outstanding, First Community had a $585 million market capitalization. To finance the acquisition with stock, First Community would have had to issue 1.04 million shares. However, the use of trust-preferred securities to finance the transaction avoided the dilution of 6.8 percent of existing shareholders’ interests.
Geographical Expansion: Atlanta-based Main Street Banks wanted to expand geographically. Main Street had $1.8 billion in assets at the commencement of 2003 and 27 branches operating in metropolitan Georgia. It offered banking, brokerage, insurance and mortgage products. Main Street thought that First Colony Bancshares offered an attractive opportunity. With $320 million in assets, First Colony had an impressive franchise in the northern part of the state, which would enable Main Street to diversify its corporate and retail customer base as well as diversify risk in its loan portfolio.
The $96 million acquisition of First Colony by Main Street in the second quarter of 2003 was financed with 2.6 million Main Street shares, then trading at $21.28, and $45 million in cash, which came in the form of proceeds from a trust-preferred issuance pooled in a collateralized debt obligation. At the time of the transaction, Main Street had 16.8 million shares outstanding. The $45 million cash portion of the transaction, financed with TruPS priced at LIBOR plus 325 basis points, avoided the issuance of 2.1 million shares of common stock. Thus, trust-preferred securities enabled the holders of the bank’s 16.8 million shares outstanding to avoid dilution of 12.5 percent.
Main Street emerged from the transaction not only reenergized strategically but also a much better-capitalized bank. Prior to the transaction, Main Street had tier-1 capital of $139 million consisting solely of shareholder equity and retained earnings. After the transaction, Main Street had tier-1 capital of $239 million, consisting of shareholders’ equity of $189 million and $50 million of trust-preferred securities.
Enhancing Shareholder Returns: Oregon Pacific Bancorp, operating in Oregon’s coastal and island communities, is a tiny bank holding company with just $138 million in assets; it trades on the OTC Bulletin Board. It was impressive in every respect but its size; its net-interest margin of 5.35 percent bested most regional and money center banks. Despite strong fundamentals, growing loan volume, and a virtually unchallenged franchise in its market, Oregon Pacific was not institutional-grade. However, inside of a pooled issuance of trust-preferred securities, Oregon Pacific was able to raise $4.1 million, enhance its capital base, and make a positive contribution to the overall CDO.
In addition to facilitating derivative access by institutional investors to Oregon Pacific’s strong fundamentals, the proceeds from the trust-preferred securities also allowed Oregon Pacific’s shareholders to enhance their return on equity by financing a common stock share buyback. In essence, the TruPS CDO structure created a bridge that permitted fixed-income institutional investors, as well as individual equity investors, to recognize the inherent value of Oregon Pacific by filtering out the inefficiencies of its size and trading venue.
In all three instances, TruPS enabled the institution that issued them to grow their risk-based assets or to enhance capital ratios, or both. The hypothetical example below provides a closer look at what happens when trust-preferred securities are issued from the perspective of three ratios that regulators focus on: the total risk-based capital ratio, the tier-1 risk-based capital ratio, and the tier-1 leverage ratio.
• The total risk-based capital ratio is total risk capital (tier-1 plus tier-2) divided by total risk-based assets.
• The tier-1 risk-based capital ratio is tier-1 capital divided by total risk-based assets.
• The tier-1 leverage ratio is average total assets for leverage (average assets less intangible assets) divided by tier-1 capital.
Generally speaking, U.S. bank regulators designate a bank well-capitalized if the total risk-based capital ratio is at least 10 percent, the tier-1 capital ratio is at least 6 percent, and the tier-1 leverage ratio is at least 5 percent. The hypothetical banking corporation in Fig. XXX, with $280 million in assets, $15 million in tier-1 capital and $10 million in tier-2 capital, has excess risk-based capital, tier-1 risk-based and tier-1 leverage ratios of 10.64 percent, 6.68 percent and 5.66 percent respectively.
Cindy: talk to David about these charts; they need to be revised.
Hypothetical Banking Corp.
Current Capital Statistics
Institution Type BHC
Total assets $280,000
Total equity $15,000
Tier-1 capital $15,000
Tier-2 capital $10,000
Total risk-based capital $25,000
Total risk-weighted assets $235,000
Average total assets for leverage $265,000
Trust-Preferred Issued $0
Max Total Trust-Preferred – Tier-1 $5,000
Equity Capital to Total Assets 5.36
Total risk-based capital ratio 10.64
Tier-1 risk-based capital ratio 6.38
Tier-1 leverage ratio 5.66
Excess Capital & Maximum Increase in Assets
Total risk-based capital ratio 10.00%
Total risk-based capital ratio – excess $1,500
20% risk-weighted – asset growth $75,000
50% risk-weighted – asset growth $30,000
100% risk-weighted- asset growth $15,000
Tier-1 risk-based capital ratio 6.00%
Tier-1 risk-based capital ratio – excess $900
20% risk-weighted – asset growth $75,000
50% risk-weighted – asset growth $30,000
100% risk-weighted- asset growth $15,000
Tier-1 leverage ratio 5.00%
Tier-1 leverage ratio – excess $1,750
Asset growth $35,000
Source: Cohen Brothers & Company, Philadelphia,PA
Without any new capital, the institution can grow its corporate loan portfolio (100 percent weighted) by just $15 million and its mortgage portfolio (50 percent risk-weighted) by just $30 million. Assets that are not risk-weighted, such as government securities, or assets that are risk-weighted by just 20 percent, consisting primarily of intercompany transfers and loans, do not represent the kind of growth that offers the likelihood of a premium for the company’s publicly-traded common equity.
If the institution’s marketplace demands loans that are 100 percent risk-weighted, then the most it can expect to grow in the coming year without any new capital is just 5.36 percent ($15 million/$280 million), a rate not likely to earn its publicly-traded shares a premium.
How does the introduction of $5 million in trust-preferred securities change the scenario?
Hypothetical Banking Corp. with
Application of $5 million of TruPS
Additional:
Trust-Preferred Securities $5,000
BHC
Total Assets $285,000
Total equity $15,000
Tier-1 capital $20,000
Tier-2 capital $10,000
Total risk-based capital $30,000
Total risk-weighted assets $235,000
Average total assets for leverage $265,000
Equity Capital to Total Assets 5.26
Total risk-based capital ratio 12.77
Tier-1 risk-based capital ratio 8.51
Tier-1 leverage ratio 7.55
Excess Capital & Maximum Increase in Assets )
Total risk-based capital ratio 12.77%
Total risk-based capital ratio – excess $6,500
20% risk-weighted – asset growth $325,000
50% risk-weighted – asset growth $130,000
100% risk-weighted – asset growth $65,000
Tier-1 risk-based capital ratio 8.51%
Tier-1 risk-based capital ratio – excess $5,900
20% risk-weighted – asset growth $491,667
50% risk-weighted – asset growth $196,667
100% risk-weighted- asset growth $98,333
Tier-1 leverage ratio 7.55%
Tier-1 leverage ratio – excess $6,750
asset growth $135,000
Source: Cohen Brothers & Company, Philadelphia, PA
With the application of $5 million in TruPS, the same hypothetical institution can grow its 100 percent risk-based assets by $65 million and achieve annual growth in assets of 22.81 percent, a rate at which its common equity can perhaps command a premium.
For a moment, let’s cast aside the demands of the marketplace and focus on total asset growth through the tier-1 leverage ratio. The application of $5 million of trust-preferred securities would offer total maximum asset growth of $135 million, or 47.37 percent, compared with 12.5 percent without the application of TruPS. For management teams that are predisposed toward growth, TruPS offers a flexible and inexpensive tool.
The rapid rise of TruPS CDOs is attributable not just to the supply of collateral but also the demand from investors. Among institutional investors seeking yield, TruPS offer a premium over other similarly-risked securities.
Once TruPS were pooled from several depositories into a single CDO, an entire new segment of the banking market -– regional and community banks –- was opened up to institutional investors.
This was a significant and positive development. To understand why, consider the performance of small banks, those with assets of less than $1 billion, versus larger banks, those with assets greater than $1 billion over time.
For instance, the marked difference in core funding has a direct impact on the net-interest margin of large banks versus small banks. Because a larger percentage of the funding for smaller consists of relatively inexpensive deposits, they are, on average, able to earn higher net-interest margin spreads.
Source: FDIC
Not surprisingly, smaller banks are more liquid than their larger competitors when these core deposits are measured as a percentage of total assets.
Source: FDIC
In addition to higher liquidity, smaller depository institutions offer greater safety because they tend to have higher loan quality.
Source: FDIC
In addition, smaller banks offer a higher degree of safety because they generally maintain higher capital-adequacy ratios.
Source: FDIC
Yet for this diminished risk, smaller banks offer investors comparable or, at times, superior return on assets.
Source: FDIC
It’s little surprise that smaller banking institutions were a source of frustration for investors: They had attractive collateral features but no realistic access through the debt markets. They had diminished or even exasperating access through the equity markets, since many institutions trade less than 10,000 shares a day. This liquidity issue is aptly illustrated by Fig. XXX, which shows comparative liquidity of large banking institutions versus smaller ones.
Source: SNL Financial, Cohen Brothers & Company
However, the pooled CDO approach overcame the structural impediments of the issuers and their trading patterns. For the first time, large institutional investors could realistically diversify their risk profile within the banking segment. Because of this, new issues of TruPS CDOs have been enthusiastically received by institutional investors; this suggests a likely increase in overall volume during the next five years.
Interestingly, in late 2003, just as TruPS CDOs were gaining momentum, their tier-1 capital treatment was called into question by a Financial Account Standards Board interpretation of Variable Interest Entities. The Board revised FASB Interpretation No. 46, “Consolidation of Variable Interest Entities,” with FIN 46R. The revision came in response to Enron and the role that Special Purpose Entities played in the catastrophe. However, the apparent resolution of this issue may have ultimately strengthened the foothold that TruPS CDOs gained in the banking industry.
Shortly after this interpretation, the Federal Reserve proposed amendments to its risk-based capital rules, which included, among other items, continued tier-1 capital treatment for trust-preferred securities. In support of these amendments, the Federal Reserve made several clarifying remarks that appear to have secured the tier-1 status of trust-preferred securities.
In citing its reasons for the continued inclusion of TruPS in tier-1 capital, the Federal Reserve recalled a supervisory experience that was characterized as “positive.” In the proposed amendments, the Federal Reserve noted, “Trust-preferred securities have proven to be a useful source of capital funding for BHCs, which often downstream the proceeds in the form of common stock to subsidiary banks, thereby strengthening the banks’ capital bases.”
The Federal Reserve went further in its support of trust-preferred securities, not just as stand-alone instruments but also as pooled securities inside of a CDO. “From a competitive equity point of view, poolings of trust-preferred securities have permitted small BHCs for the first time to access the capital markets for tier-1 capital, which larger BHCs have long enjoyed. No alternative tier-1 structure to trust-preferred securities has emerged . . .” The Federal Reserve noted that with respect to large BHCs, preventing access to a tax-efficient capital instrument might place them at a competitive disadvantage to foreign banks, which already have $125 billion of similar tax-efficient capital on their books.
Most importantly, in its proposed amendments the Federal Reserve addressed how the recent interpretations by the FASB — FIN 46 and FIN 46R — could lead to new GAAP treatment of trust-preferred securities issued out of a special purpose entity on the balance sheet of a bank holding company. And while the Federal Reserve reiterated its longstanding direction that bank holding companies are required to follow GAAP for regulatory reporting purposes as well as accounting purposes, it went to some lengths to parse the logic of interrelated regulatory bodies to assert its dominion over the affairs of banking institutions –- particularly with respect to the regulatory definition of capital.
Specifically, “The change in the GAAP accounting treatment of a capital instrument does not necessarily change the regulatory capital treatment of that instrument. Although GAAP informs the definition of regulatory capital, the Federal Reserve is not bound by GAAP accounting in its definition of tier-1 or tier-2 capital because these are regulatory constructs designed to ensure the safety and soundness of banking organizations, not accounting designations designed to ensure the transparency of financial statements. The current definition of tier-1 capital differs from GAAP equity in a number of ways that the Federal Reserve has determined are consistent with its responsibility for ensuring the soundness of the capital bases of banking organizations under its supervision.”
With this regulatory orientation firmly established by the Federal Reserve, it would appear that the growth and longevity of the TrusPS CDO market is a three-legged stool. Issuer benefits of cost, tax efficiency and anti-dilution are met in equal measure by investor benefits of yield premium, access to the entire continuum of the banking industry, and the opportunity to diversify their risk profile. However, supply and demand appear to be substantially buttressed by a favorable regulatory outlook for TruPS.
