When passing the hat around the board table doesn’t improve your ratios, you may be going outside the bank for capital. Mourning for pooled trust preferred won’t help.

Stack that capital

Period of turmoil has banks looking for capital where and how they can find it

When a community bank, or even a somewhat larger institution, requires added capital, it isn’t unusual for the board chairman to ask directors how much they can manage to cough up to help the bank with expansion plans, or to help bolster its capital ratios.

But before one can add something to the hat, there’s got to be something in the pocket. And banking attorney Walter Moeling IV notes that in many boardrooms around the country, pockets aren’t quite as deep or full as they once were.

“The first place community banks usually start for more capital is passing the hat around the board table,” says Moeling. Many local directors, from real estate brokers to builders to suppliers to plumbers, have direct or indirect ties to the real estate industry, says Moeling, and many therefore lack liquidity today.

The larger the institution, the less the proverbial hat looks like an investment bank, in any event, with some exceptions. (See the box, “Missouri’s First Banks forms ‘bad bank’ to aid asset cleanup effort,” p. 28.)

“There’s a big need for capital in the banking sector today, not only in the big banks, but also in the small and mid-sized banks as well,” says Rick Maples, co-head for investment banking and head of the Financial Institutions Group at the investment bank Stifel Nicolaus, St. Louis.

“The largest number of community banks will be seeking new capital than I have ever seen at any one time, and that’s over a 40-year career,” says Moeling.

Sources of capital hunger
Driving the appetite for more capital are several factors.

Clearly, troubled institutions want more capital. Many are laboring under regulatory orders to find it.

“You can argue solvency forever,” says Moeling, co-chair of the Financial Institutions Practice Group at Powell Goldstein LLP, Atlanta, “but you need liquidity to keep the bank’s doors open. And to get liquidity, you need the capital.” Some can still find it, though at a price, while others the market has already written off, and it may be all over but the scrambling.

Regulatory urging outside of the formal orders also drives the hunger. This comes in two forms.

The first is jawboning from Washington. In mid-May, Federal Reserve Chairman Ben Bernanke stated:

“Recent events have … demonstrated the importance of generous capital cushions for protecting against adverse conditions in financial and credit markets. I have been encouraged by the recently demonstrated ability of many financial institutions, large and small, to raise capital from diverse sources. Importantly, capital raising and balance sheet repair allow for the extension of new credit, which supports economic expansion. I strongly urge financial institutions to remain proactive in their capital-raising efforts. Doing so not only helps the broader economy, but positions firms to take advantage of new profit opportunities as conditions in the financial markets and the economy improve.”

Such rhetoric, reports from the field indicate, is being matched by closer attention to capital from bank examiners. Capital has always been important. However, even though it is broadly recognized that many community banks, and the industry as a entirety, remain strongly capitalized according to current capital standards, there is a push for still more cushioning.

More and more, “the regulators are asking for what I call ‘super-capitalization’,” says Philip K. Smith, president of the Memphis-based law firm Gerrish McCreary Smith, P.C., with examiners pushing for ratios beyond the minimums set for well-capitalized banks.

Consultant Jay Brew of M.Rae Resources, Inc., Bethlehem, Penn., says he’s heard clients quote examiners as saying that they are less concerned these days about earnings than they are interested in seeing well-capitalized banks that are well-provisioned for potential loan losses.

Institutions with deteriorating asset quality, and either facing the eventual need to hike the allowance for loan and lease losses, or already into that, are also seeking more capital. Other institutions simply want to make sure they are well cushioned, and want to make it clear they are cushioned.

“Bulletproof capital and bulletproof liquidity will help you weather the storm,” says Thomas W. Killian, principal, in the investment banking group at New York’s Sandler O’Neill & Partners, L.P. Adds Richard D. Hitt, at Navigant Consulting, Inc., Chicago: “You’ve got to separate yourself as soon as possible from other institutions. The real challenge, from the valuation standpoint today, is the market’s tendency to paint everyone with the same worst-case-scenario paint brush.”

Experts say the most prescient of healthy institutions loaded up on capital when availability and prices were more favorable.

And then, let’s remember that capital isn’t just for impressions on analysts, examiners, and the public. Other healthy, expansion-minded institutions seek more capital today to continue exploiting opportunities they see for growth. Not everyone is hunkering down.

Testimony to the appetite was heard in late July during a conference call that officials of KBW Inc., New York, specialized bank-oriented investment banking firm, had with stock analysts. They indicated that many institutions’ “mood went from denial to shock” from the first quarter to the second.

In part because of an improvement in market conditions, “people who need capital are starting to think a lot harder about it,” said John Duffy, KBW’s CEO. He noted that his capital- raising executives were doing a brisk business, and that his firm’s role in placing a $600 million private placement for Guaranty Financial Group, Inc., of Texas, garnered KBW its biggest-ever underwriting fee. Indeed, the firm told analysts that capital demand was such that banks’ negotiations over price have been “a little less intense” than two years ago.

Sources of frustration
Banking companies of all sizes have been facing a multifold challenge in recent months in the capital arena.

First, stigma. “There is a pox on all banks and there is very little discernment among them,” says investment banking veteran Charles Miller, managing director of Silverton Bank, N.A., the Atlanta-based banker’s bank. “The markets are convinced that if you don’t have trouble now, it’s coming.” This has driven shares of publicly traded banks to 20-year lows, making banks loathe to issue new common shares and investors wary of buying them when they think the downward trip isn’t over yet.

This, and the trust preferred trends that will be examined in a moment, have driven up costs.

“The banks that are stressed will pay a big price for their capital,” if they can get it, says Rick Maples of Stifel Nicolaus. “That’s not growth capital. It’s stabilization or ‘save-the-bank’ capital.”

One source that some banks in difficulty have used in one form or another are rights offerings—issuance of rights to current shareholders that allow them to purchase additional shares, generally at a discount to market price. Shareholders who don’t take advantage of the offerings face dilution of their interests. Industry experts expect to see more of these, as publicly traded banks seeking recapitalization attempt to hold their costs down and appeal to existing shareholders.

“Debt’s out there, but it’s expensive,” observes Helen Sullivan, senior vice-president—capital markets, for ABA’s Total Business Solutions unit. (This unit oversees administration of the ABA NASDAQ Community Bank Indextm, www.aba.com/About+ABA/ABAQ.htm)

The second major factor at play is trust preferred. Banks have had to say goodbye to pooled trust preferred securities as a source of capital. The pools got caught up in the collateralized debt obligation debacle and they are currently at a standstill.

Midsize banks, especially, were spoiled by the easy, relatively cheap availability of trust preferred, says Sandler’s Killian.

It’s hard to bid farewell to such advantageous funding. Some trust preferred deals are now being done as private placements, but the costs are vastly different.

Stifel Nicolaus’ Rick Maples says prices are higher for the standalone trust preferred deals that have gone through, compared to the pooled deals of the past, even when the company involved is a good risk. “The good companies have better access to capital than the other companies do today,” says Maples, but they still pay for it.

Maples paints an expensive picture. A year ago, he says, a community bank could have obtained trust preferred capital at LIBOR plus 140 to 200 basis points, coming out to roughly 5%. Shortly before the market crumbled, he continues, his firm did a few deals at 300 basis points over LIBOR.

Now, the economics have changed. His firm recently did private trust preferred deals for two strong firms: Southwest Bancorp, Inc., a $2.7 billion-assets three-bank holding company in Kansas, at 10.5%, and another for PrivateBancorp, a five-bank, $6.3 billion-asset bank holding company in Illinois, at 10%.

“So,” Maples continues, “the cost of trust preferred has doubled or even more.”

To a degree, the pricing runup, painful as it is, has to be taken in context. “This is a return to a normal risk reward ratio for the investor,” says ABA’s Helen Sullivan.

Convertibility sells
The trend toward obtaining capital from demanding private equity investors summarized in the box, “Private equity funds take a shine to banking,” which previews an extensive report on www.ababj.com. Silverton’s Charles Miller says another factor to be aware of is that investors give everything a gimlet eye now. They are inclined to look at any form of capital already issued, and insist, in the pricing of a new deal, on a 20%-30% “haircut,” to use his term, off the current market price. Miller takes this as proof that even though there are willing buyers, they are skeptical that the worst has been seen, and are insuring themselves. He adds that some organizations have not taken such haircuts, but explains that that is only because their securities had already taken a market shellacking.

Another, related factor, is that investors are demanding upside potential, as well. A trend is developing that experts predict will grow stronger, towards securities issued currently being convertible into common shares. Miller’s organization, for instance has done some convertible trust preferred paper, with the securities convertible into common at prices higher than the current market.

“The market was throwing money at bank capital issues a few years ago,” says Miller. “But now, it’s like pulling teeth.” BJ

10 outside-the-box strategies for when capital needs a boost

When it’s time to decide “don’t raise the bridge, lower the river.”

An old saying runs, “Don’t raise the bridge, lower the river.” That may be extreme in this context, but there are alternatives to raising new capital, or doing so in obvious ways and traditional channels.

1. De-leverage the balance sheet. Think “financial liposuction” or “accounting analgesic.”  Consultant Michelle Gula of M.Rae Resources, Inc., suggests selling off loans and investments; dropping deposit rates to run off hotter money; and in general finding ways to reduce the need for capital. De-leveraging makes existing capital go further.

For instance, Gula says, “some banks have assets on the books that they are carrying at a negative spread, and they could de-leverage such things.”

2. Combine shrinkage with strategic redirection. Building on Gula’s tactic, investment banker Tom Killian of Sandler O’Neill suggests using de-leveraging as an opportunity to change the bank’s risk profile and to reduce concentrations in the loan portfolio. For instance, this is a good time to sell off nonperforming assets and other real estate owned, rather than carrying it with an accompanying capital and loss allowance burden. Likewise, a review of the bank’s funded and unfunded construction loans may reveal opportunities to sell to other lenders or asset buyers, with the idea of reducing borrower and loan-type concentration.

3. Adopt a temporary slow-growth or no-growth strategy. Maybe a diet, not liposuction, is appropriate. Not all banks, based on their markets or their ownership, have the option of simply hunkering down, but Tom Killian says that where it is, this can help banks with flexibility in skirting the need for more capital. Mark Aldrich, principal with the California banking law firm Aldrich & Bonnefin, P.L.C., says he hasn’t seen much de-leveraging among his 200+ clients in his state, but he has seen efforts to curtail further growth.

4. Make sure capital is what you really need. M.Rae’s Gula says one client recently came to the firm for capital advice. Crunching the bank’s numbers indicated what it really needed was core deposits, and the firm helped it reorganize its offerings to attract more core.

5. Bring nonbank subsidiaries back into the bank. Certain types of nonbanking subsidiaries, such as a bank-owned mortgage bank, may have their own separate capital structures. Sandler O’Neill’s Tom Killian says that in some cases it can make economic sense to turn such operations into bank divisions. A mortgage bank that has its own capital, for instance, can be turned into a mortgage department funded through secondary market sales and deposits, with its nut of capital becoming available to the bank.

6. Tap the holding company. If the bank has a holding company, the holding company can borrow against a subsidiary bank’s stock, Gula notes. Loan proceeds are pushed down to the bank as capital.

7. Consider forming a “bad bank.” The box “Missouri’s First Banks forms ‘bad bank’ to aid asset cleanup effort,” p. 28, details one institution’s efforts. Navigant Consulting’s Richard Hitt says he expects this strategy to “get legs” in the months ahead.

8. Try your banker’s bank. Silverton Bank, N.A., Atlanta (formerly The Bankers Bank, N.A.), has been making convertible trust preferred capital available, according to Silverton’s Charles Miller. However, this trust preferred program, in which the shares are sold to other entities after Silverton concludes the deal, is open solely to the 400-plus members of this banker’s bank.

“We’re reserving it for our existing customers,” says Miller. “There are only so many seats on this boat.”

Banker’s banks members may also be able to obtain other helpful services, such as bank-stock loans and other aids to liquidity.

9. Explore alternative structures. Mutual institutions haven’t typically enjoyed the same range of capital options as stock institutions. And typically when they formed mutual holding companies, they formed a second entity, a bank holding company, standing between the parent and the institution, notes banking attorney Philip Smith of Gerrish McCreary Smith. His firm believes it has found a way to simplify things for mutuals by eliminating the middle layer. The matter is currently under evaluation by the Office of Thrift Supervision.

10. Rethink traditional attitudes about capital. Many means of directly increasing capital have the potential of immediately or eventually diluting current stockholders. Dilution is a dirty word in a world where bankers worry about increasing shareholder value.

“But if the issue is dilution versus being closed,” says banking attorney Walter Moeling of Powell Goldstein, “dilution looks pretty good.”

And then there is the anti-dilutive alternative.

Philip Smith suggests that smaller publicly traded banks with severely depressed shares can turn today’s environment into an opportunity to take themselves private.

Rock-bottom prices represent a cheap opportunity to acquire and retire bank shares, in order to fall back below mandatory registration parameters. These institutions can bid farewell to Sarbanes-Oxley and other burdens in the process.
—Steve Cocheo, executive editor

 Missouri’s First Banks forms “bad bank” to aid asset cleanup effort

Unusual capital injection facilitates workout plan.

Like many other banks around the country, St. Louis’ First Banks, Inc., has been having trouble with nonperforming commercial real estate loans, notably land acquisition and development loans. But the $10.3 billion-assets holding company has taken a very atypical path to addressing the troubled assets and accompanying stress on capital: formation of a “bad bank.”

A celebrated example of this general strategy was creation of Grant Street National Bank in 1988 (ABA BJ, April 1990). Grant Street was chartered by Mellon Bank Corp. as a spinoff, a separately owned institution held by Mellon shareholders. Grant Street, financed by  part of a $525 million recapitalization by Mellon, existed to take on and resolve $1 billion of Mellon’s nonperforming loans.

First Banks took a somewhat different tack in May, when it formed FB Holdings, LLC, a majority-owned subsidiary of the holding company’s First Bank. The holding company placed approximately $104.1 million of loans and other assets into the subsidiary. The minority partner, First Capital America, Inc., contributed $100 million in cash to the subsidiary. The cash contribution appears as a minority interest in the holding company’s consolidated financial statements.

First Capital America, source of the $100 million capital infusion, is owned by James Dierberg, a noted bank investor, and his family. The Dierberg family trusts owns all of the voting stock of First Banks, Inc., which has banking operations in California, Florida, Illinois, Missouri, and Texas.

Clearly, action was necessary. First Banks reported a net loss of $44.8 million for the first six months ending June 30, 2008, versus earnings of $34.8 million for the comparable period of 2007, with accompanying increases in the provision for loan losses.

However, so long as the Dierbergs were reaching into their own pockets for fresh capital, and dilution wasn’t an issue, why not buy more common stock?

One reason was to buy more time for First Banks to clean up the bad loans. Workout teams in the bank’s five regions are tackling the problem credits, disengaging mainline staff from them.

But the structure was developed by the holding company and its accounting and legal advisors for very specific reasons—estate planning and tax planning, according to Lisa K. Vansickle, senior vice-president and chief financial officer at First Banks. (While regulatory approval wasn’t per se required, Vansickle says management briefed regulators in advance, and provided pro forma data. Once the mechanism had been launched, formal confirmation of the move was given to the agencies, as well. Vansickle says the bank was under no enforcement order, and took the action on its own.)

Vansickle explains that if the Dierbergs had contributed capital in the form of fresh common stock, dividends paid on those shares would have been subject to double taxation, once at the holding company level, and once at the family’s level. Under the “bad bank” arrangement, return on the additional capital will only be taxed once.

“So this structure allows us to get capital into the bank and meet the expectations of shareholders,” says Vansickle. Given more time to work out the troubled assets, Vansickle says, the company anticipates a greater final return.

Structured as it is, the $100 million in new capital serves as the equivalent of trust preferred stock. Banking companies are limited in terms of how much trust preferred and similar capital forms can be counted towards Tier I. First Banks already has about $345 million in trust preferred, the result of both public and private offerings, according to Vansickle, and could count no more towards Tier I. However, the new capital is still includable in Tier II, so the company saw that ratio rise in the wake of the maneuver.
—Steve Cocheo, executive editor

This article was posted on ABA Banking Journal, www.ababj.com, and is copyright 2008 by the American Bankers Association.

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