|Got TARP? You need a game plan to go with it (January 2009)|
Suddenly, Uncle Sam was giving out capital to qualifying banks. For many the deadline came up so fast, there was no time for detailed planning. What’s the best way to use this unique form of capital? A veteran investment banker details seven roads to maximum “Return on TARP.”
By Thomas W. Killian, principal, Sandler O’Neill & Partners, N.Y.C.
There are some very intriguing ways to use TARP funds, and some have smaller windows of opportunity than others. Here’s advice on strategy
The most significant regulatory intervention in U.S. banking since the Great Depression was just launched in the form of the $700 billion Troubled Asset Resolution Program (TARP) and its $250 billion TARP Capital Purchase Program (CPP).
Treasury is currently allocating funds in the TARP CPP and has spelled out its pricing and terms for participation. While the timing from initial announcement in mid-September to the Nov. 14 and Dec. 8 deadlines for application for TARP has been startlingly quick, banks that received TARP funding can catch their breath and begin to think through the strategies to best take advantage of this newfound capital.
To assist, this article will examine the TARP programs and the related FDIC debt guarantee programs. We will identify key benefits and risks of participating in TARP and review key banking strategies for 2009 and beyond.
Background and impact
As a historical note, from 1933 to 1935, the Reconstruction Finance Corp. (RFC) purchased more than $1.7 billion in preferred stock from 6,104 banks. By the program’s end in 1935, RFC had a substantial voting interest in half of the nation’s commercial banks. The terms for today’s TARP Senior Preferred Stock (“TARP Preferred”) and associated warrants are summarized in the box “TARP Preferred Terms,” at the right.
The TARP Capital Purchase Program set aside $250 billion of funding for investments in banks and thrifts. The program was kicked-off by nine large institutions which committed to receive $125 billion of funds. Banks whose shares are traded on major exchanges were asked to submit their application by Nov. 14. Through Dec. 15, 203 publicly traded banks (including the original nine) had been given approval to receive about $246.8 billion in funding. About 3,110 private institutions were excluded from the public TARP program, but were later extended an invitation to apply for TARP funding by Dec. 8. The issuance terms were largely the same for private institutions, except that Treasury will receive warrants to purchase preferred stock with a liquidation value of 5% of the face amount of the TARP preferred, a dividend rate of 9%, and an initial exercise price of one cent.
The benefits of participating in TARP CPP are straightforward:
• Access to the least expensive form of equity capital currently available
• Anticipates potential guidance to higher capital levels
• Provides increased ability to fund growth, expansion, and acquisition opportunities
• Creates minimal dilution that can be offset with investment in interest-earning assets
• Provides a market perception of financial strength
The risks of participation in the TARP preferred program are more qualitative:
• Difficult to achieve reasonable return on “excess” capital.
• Restrictions on dividend increases or/and stock buybacks.
• Potential earnings per share dilution.
• Potential corporate governance impact.
• Vagaries of contract with regard to future lending and loan workouts.
• Risk of greater government involvement in the future.
In addition to the TARP preferred capital purchase program, the government, through FDIC, also authorized the Temporary Liquidity Guarantee Program (TLGP) and its Senior Unsecured Debt Guarantee Program on Nov. 21, 2008. The TLGP program will guarantee new senior, unsecured debt with maturities greater than 30 days issued on or before June 30, 2009. All FDIC-insured depository institutions are eligible to participate, along with bank and financial holding companies and certain savings and loan holding companies. The amount of debt which may be issued under the program is generally limited to 125% of the senior unsecured debt outstanding at Sept. 30, 2008, that is scheduled to mature by June 30, 2009. The limit for institutions without any senior unsecured debt outstanding at Sept. 30, 2008, is determined based on the type of institution—for insured depositories it’s 2 % of consolidated liabilities; holding companies need to consult with FDIC. Similar to the pooled trust preferred market, we have now seen a market beginning to develop for FDIC-guaranteed senior unsecured debt issued through a pooled passthrough security structure.
Key banking strategies
The failures of Bear Stearns, Lehman Bros., and IndyMac point to the critical importance of developing contingent liquidity and capital plans well in advance of a crisis—and testing them in advance to make sure they will really be there when needed. Those institutions receiving TARP proceeds or issuing debt under the TLGP program should turn their attention to strategies to optimally deploy the capital in 2009 and beyond. These key strategies are discussed below.
Increase lending activity to take advantage of revised pricing and terms that reflect changes in the marketplace.
Given the general deterioration in the economy and increase in nonperforming assets, lending activity has slowed throughout the banking system. This lack of available credit has created an opportunity to return to more normal pricing and terms, which will allow significantly wider credit spreads, collateral coverage, and tighter documentation. Banks should consider strategically increasing lending activity where the revised pricing and terms present attractive risk-reward opportunities to support their local markets.
Augment available capital and develop contingent capital and liquidity plans to support current and future business opportunities.
Despite the fact that TARP preferred dividends are cumulative, Treasury has explicitly stated that the TARP preferred will be considered core capital and will expand the base against which the Tier 1 qualifying amount of trust preferred and other preferred capital will be measured. As such, an increase of $100 million of TARP preferred could be viewed as supporting an additional issuance of 25% of the pro forma core capital, or roughly $33 million of Tier 1 qualifying trust preferred securities. Thus, bank and thrift holding companies can utilize the TARP preferred to qualify more of their existing trust preferred securities for Tier 1 capital treatment. Eligible banks should also consider issuing up to 2% of total liabilities through the FDIC guarantee debt program as a way to supplement current funding sources.
Begin planning to repay or refinance the TARP preferred as market conditions improve in order to chop the warrant coverage in half.
Qualified issuance of additional core capital raised before Dec. 31, 2009, will reduce the warrant coverage from 15% to 7.5%. As such, TARP issuers should carefully evaluate opportunities to raise core capital to take advantage of this opportunity for warrant reduction while also preparing to ultimately repay the TARP preferred, when callable three years from issuance.
Use capital to support aggressive loan loss reserve additions, non-performing asset sales, loan modifications, and other balance sheet restructuring programs.
Asset quality trends continue to deteriorate, with net charge-offs totaling $27.9 billion or about 1.42% of total loans through Sept. 30. Noncurrent loans and leases now total $184.3 billion and are up 122% or $101.2 billion since Sept. 30, 2007. The combination of high level charge-offs and significant increase in noncurrent loans and leases has caused loan loss reserve coverage to fall to 0.85% — the lowest level since the peak of asset quality problems in the 1993 cycle. In this uncertain asset quality environment, investors are very focused on banks’ ability to reduce their risk profiles with potential problem asset categories such as land acquisition and development loans, option ARM mortgages, HELOCs, and credit card loans. Banks should evaluate the cost and benefits of a more accelerated resolution of problem assets, given the flexibility afforded by additional capital.
Pursue branches, deposits, and other assets being sold by FDIC from the resolution of problem banks.
As of Dec. 16, 2008, 25 banks and savings institutions had failed. At the end of the third quarter, the latest numbers available, 171 banks representing about $115.6 billion in assets were considered troubled.
As such, there will likely be tremendous opportunities for well-capitalized banks to acquire branches, deposits, and other assets being sold by FDIC as part of the resolution process. By purchasing such assets through FDIC, buyers can generally avoid legacy risks or liabilities that would be present in a whole-bank acquisition.
To be in the best position to benefit, banks should screen, by local market, the branches that may be available and develop a point of view on the attractiveness of the various locations. It pays to be proactive—in many cases, these transactions are arranged quickly.
Deploy capital to pursue accretive whole bank acquisitions.
As mentioned, 203 banks had obtained approval to receive approximately $246.8 billion of TARP preferred stock. As of Dec. 15, 2008, there were 112 institutions awaiting approval or having interest in TARP capital and 97 who have declared that they will not apply.
The private bank TARP program had only recently been announced at the time this was written, and we did not have results on how many banks will participate. But if all private banks participated and received the full 3% of total risk-adjusted assets, this would require about $20 billion of additional capital from TARP. (At press time, no plan had been announced for the 3,074 Subchapter S corporations nor mutual institutions.)
Those who do not participate in the TARP program will be placed under severe pressure to find additional capital or a merger partner. This will no doubt present many opportunities for “fill in” and other acquisitions that could be immediately accretive to earnings. These priority targets should be identified and reviewed from public information. Whole-bank acquisitions require much more due diligence, but properly structured, these transactions can provide significant scale and earnings pickup.
Deploy capital to purchase highly rated securities trading at significant discounts and attractive yields.
Rarely have yields on AAA-rated securities traded at such high levels—in some cases, they exceed 10%. Concerns of further credit deterioration of the underlying collateral and the lack of liquidity to fund such assets are causing yields to soar.
To the extent that a bank has access to sufficient capital and insured deposit funding, very attractive net interest spreads can now be generated between the 9% to 11% yielding AAA-rated mortgage backed securities and the 3.5% to 4.5% cost of deposits or borrowings. To develop a comfort level on the underlying credit risk, potential bank investors should re-underwrite the credits, or at least probe into the performance of the underlying collateral. These rate relationships will likely return toward historic norms once asset quality stabilizes and balance sheet liquidity returns to more customary levels.
If the historical precedent of the Reconstruction Finance Corporation of 1933 is any indication, the TARP CPP program can play a very positive role in stabilizing the capital and liquidity needs of the U.S. banking system. BJ
TARP Preferred Terms
Initial dividend rate 5% increases to 9% after year five.
Redemption At par after year three; redeemable prior to the end of year three with the proceeds from a common stock or a Tier 1 perpetual preferred offering equal to at least 25% of the issue price of the TARP Preferred.
Transferability No restrictions; institutions must file a shelf registration covering the TARP Preferred and warrants as soon as practicable.
Dividend restrictions Common dividends cannot be increased without Treasury approval until the third anniversary of the issuance unless the TARP Preferred has been redeemed or transferred; dividend payments on common, junior preferred, or pari passu preferred are prohibited if in arrears on TARP Preferred Dividends.
Repurchase restrictions Treasury consent required for most share repurchases until the third anniversary of the investment unless TARP Preferred is redeemed or transferred.
Voting rights The TARP Preferred will generally be non-voting, except under certain limited situations.
Board seats None, unless dividends on the TARP Preferred are not paid in full for six dividend periods, whether or not consecutive. The right to elect directors will end when full dividends have been paid for four consecutive dividend periods.
Executive compensation As a condition to the closing of the investment, the company must adopt Treasury standards for executive compensation and corporate governance for the period which the Treasury holds equity issued under the program. These standards generally apply to CEO, CFO, and next three most highly compensated officers.
Key terms of warrants Treasury will receive warrants to purchase common shares with a market price equal to 15% of the TARP Preferred amount on the date of investment with an initial exercise price equal to the 20-trading day trailing average market price of the common stock on the date of the investment.
Exercise price reduction The exercise price shall be reduced by 15% on each six-month anniversary of the issue date if the consent of the QFI (qualifying financial institution) stockholders has not been received, subject to a maximum reduction of 45% (which occurs only when stockholder approval is required to approve additional authorized shares or if the applicable stock exchange requires a vote).
Term 10 years.
Exercisability Immediately exercisable, in whole or part.
Voting Shares issued to Treasury are non-voting.
Transfer Not subject to any contractual restrictions on transfer (except that only one-half of the warrants can be transferred or exercised prior to the earlier of Dec. 31, 2009 or the date where the institution has received not less than 100% of the TARP preferred issue price in a qualified Tier 1 offering).
Reduction If the participating institution raises common or perpetual preferred equal to at least 100% of the issue price of the TARP Preferred by Dec. 31, 2009, the number of warrants shall be reduced by 50%.
Substitution If the QFI is no longer listed or traded on a national securities exchange or securities association, or consent has not been received within 18 months after the issuance date, the warrants will be exchangeable at the option of the Treasury for senior debt or other instruments.
The electronic version of this article available at: http://lb.ec2.nxtbook.com/nxtbooks/sb/ababj0109/index.php?startid=28
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