Tapping Into a Rich Vein

With the recent inflow of deposits into community banks, times are good for Dana Gavenda. The president and chief executive officer of the $100 million-asset Fairport Savings Bank has seen deposits rise 5% this year, while area businesses are laying off workers in upstate New York’s sluggish economy. Fairport will open its first branch in January, an operations center later in 2003, then follow with two more branch openings in 2004 and 2005.

The burning question: how to fund it all? A few years ago, these initiatives may have forced the bank to give up its mutual status and sell stock to raise capital in order to replenish the balance sheet.

Not anymore. Now Gavenda says his bank will eventually turn to a credit instrument previously unavailable to banks of Fairport’s size. Trust-preferred securities, once only the domain of larger banks, have become increasingly used by their community counterparts as the market evolves.

“Trust preferreds are a way for us to raise capital without giving up control of the bank,” Gavenda says.

For Gavenda and hundreds of other community bankers, trust preferreds are becoming almost a necessity to remain competitive. And community banks are using them in a variety of ways, from funding de novo expansion and acquisitions to stock buybacks and paying down debt.

“The popularity of the trust preferred speaks for the utility of it in the banking industry,” says Tom Bracken, president and chief executive officer of $2.1 billion Sun Bancorp Inc., a Vineland, New Jersey bank that has issued trust preferreds to fund branch acquisitions in recent years.

A trust-preferred security is a hybrid of sorts. It is similar to equity in that it can be counted as tier-one capital, just like stock. Yet with its fixed maturity, dividend payments, and lack of voting rights, it also resembles a bond.

The advantages of trust preferreds are numerous. For one, they won’t dilute existing bank ownership. For reporting purposes, they don’t count as equity when calculating return on equity, so earnings per share is not diluted. They are also cheaper to fund than preferred stock because dividend payments are tax-deductible. And trust preferreds can count for up to 25% of tier-one capital, whereas traditional forms of debt cannot.

The frenzy over trust preferreds among banks started in October 1996, when the Federal Reserve Board issued a press release stating that banks could count the credit instruments as tier-one capital. Large financial institutions with strong credit ratings raced to issue trust preferreds in late 1996 and 1997 as private placements. They were followed by mid-size and small institutions, as private placements were a good path for companies with a non-investment-grade status. Still, left out in the cold were smaller community banks that generally look to raise $5 million to $15 million, amounts too little to generate investor interest.

But with the help of investment banking firms and brokerages, community banks started taking part in poolings of trust preferreds in 2000. Community banks soon found they could sell to investors a collaterized debt obligation that is backed by their pooled trust-preferred securities. Each bank receives capital as though it had done its own issue. In poolings, banks can automatically qualify by meeting a strict set of standards, or they can make the grade by receiving high credit scores from the rating agencies and going through the due diligence procedures of the underwriters.

“Poolings give small banks the ability to compete with larger banks,” says Fred Price, chief operating officer at Sandler O’Neill. “It allows them to grow and efficiently manage their capital base.”

Poolings are generally $300 million in size and up, with 50 or so participants, spread over five different geographic regions. No one investment can comprise more than 5% of a total pool. The diversity makes the pooling more attractive to investors.

Whether through poolings or private placements, community banks are taking advantage of trust preferreds like never before. Through poolings, about $7 billion worth of trust preferreds were issued in 2000 and 2001, primarily among two investment bank partnerships. Sandler O’Neill has historically teamed up with Citigroup’s Salomon Smith Barney unit, and Keefe Bruyette & Woods Inc. has worked with First Tennessee National Corp.’s brokerage unit. Bear Stearns, along with its regional alliance of investment banks nationwide, has joined the Sandler/Salomon team in recent issues. The following scenarios describe how some community banks have put trust preferreds to use.

UCBH Holdings Inc.

UCBH Holdings Inc., a San Francisco-based bank serving the Chinese community, recently used trust preferreds to help fund its acquisition last October of the Bank of Canton for $220 million. The purchase increased its dominance in serving the ethnic Chinese market in San Francisco and Los Angeles, with the bank’s asset size jumping to $4.9 billion, up from $3.3 billion. The purchase added 12 branches in the process, bringing its total to 30. UCBH paid with $169 million in cash and 1.3 million shares of newly issued stock for Canton. Part of the deal was funded by recent issuances of $90 million-worth of trust preferreds.

In order to get the $90 million in hand by the closing date of the acquisition, UCBH participated in two poolings for $52 million, and two private placements for $38 million, during the period August through October. Had the bank not been pressed to have the cash in hand by Oct. 28, the day of the purchase of Canton, it would have only elected to have the poolings, says Jon Downing, chief financial officer at UCBH. Private placements are more expensive over the long haul because they have annual trust fees, but in this case they allowed the bank to access capital faster, rather than waiting for the next pool to be structured. “We had to close by a certain day,” Downing explains. “The private placements allowed us to do it within the time requirements.”

The trust preferreds carry standard 30-year maturities, with dividends paid out on a quarterly basis, and rates ranging between 340 and 365 basis points above three-month LIBOR, meaning starting rates for UCBH were in the 5.225% to 5.435% range. In all, using trust preferreds is a cheap way to fund growth, Downing says, especially when considering how the payments on dividends are tax-deductible. “We have debt at a low 5% range,” he notes. “But when you think about it, the rates are effectively around 3% after tax.”

Heritage Commerce Corp.

Banks also use pools to maintain capital ratios as they grow. Heritage Commerce Corp., a $960 million bank in San Jose, California has used trust preferreds while it has expanded through de novo bank creation and acquisition. Heritage has been growing at a fast clip: The bank’s assets have more than doubled in size since the end of 1997, and earnings per share increased 29% in 2001 to 66 cents a share. It opened Heritage Bank East Bay in 1998 and Heritage South Valley in 2000 through public offerings of stock. It then purchased Bank of Los Altos in 2000. Along the way, Heritage has used trust preferreds to help bolster its balance sheet. Starting in first quarter 2000, the bank tapped four poolings, with the latest coming in third quarter 2002. All told, the bank has funneled $23 million from the issuances onto its balance sheet. At the end of 2001, it’s tier-one leverage ratio was 10.8% of average assets, significantly above the 5% threshold regulators consider as well capitalized.

“What [trust preferreds] have helped us to do is achieve high rates of growth and still maintain strong tier-one capital positions,” says Richard Coniff, president and chief operating officer. “We’re in an economy that is challenging, to say the least, and having a fortress balance sheet is a prudent way to run our company.”

Heritage’s strategy of tapping trust-preferred poolings on an as-needed basis is a common one. It allows the bank to avoid more costly private placements or retail issuances.

Poolings tend to offer the best floating rates above three-month LIBOR, and legal fees run between $10,000 and $15,000. Issuers also pay an underwriter fee of 3%, although trust fees have been eliminated due to competition among investment banks for pooling participants. By contrast, rates on retail deals can run 300 basis points higher because they are usually fixed. Legal and accounting fees run in the $200,000 range, and trust fees run $5,000 annually, making them a much more expensive proposition overall. “In today’s environment, pooling is absolutely by far the lowest cost form of capital out there,” says Chris Choate, director of investment banking for Ryan Beck & Co.’s financial institutions group.

MidCarolina Bank

While many community banks can automatically qualify for poolings, some have to go though a few more hoops.

MidCarolina Bank, a $170-million bank in Burlington, North Carolina, a young bank, having started operations in August 1997 by specializing in small-business loans and consumer lending in small-town America. Generally, for banks to autoqualify, they need to have a tier-one risk-based capital ratio of 10%, an asset size of at least $200 million, five years of operating history, no material litigation matters, FDIC-insured deposits, and consistent financial performance.

MidCarolina came up short in asset size, and its operating history was on the lineu00e2u20ac”it had been in business for five years, but didn’t start generating a profit until after 14 months.

After filing financials and other paperwork with its investment bank, Ryan Beck & Co., MidCarolina participated in a 30-minute telephone call with bankers at Bear Stearns, one of the managers of an October pooling. During the conversation, Randolph Cary, chief executive officer, was peppered with questions about its core business, why it was successful, and its growth potential in local markets. The investment bankers also focused on MidCarolina’s net-interest margin, which was 4.2%, a bit higher than the average of its regional peers. After numerous interest rate cuts by the Federal Reserve Board, why, they asked, were margins holding up so well? The answer lies in part with the bank’s conservative pricing strategy. What set MidCarolina apart from the others was the typical short duration on its certificates of deposit, 95% of which have a maturity of six months or less. Even though adjustable rate loans were repriced immediately after each rate cut, the bank wasn’t locked into deposit rates for very long. While the net margin dropped to 3% during the Fed cuts, it has since rebounded to 4.25% because of the quick repricing of its deposits. “We do kind of stick to our niche,” says Cary. “We don’t do anything really sexy.”

After the phone call with Bear Stearns, Cary had an approval the next day. “Part of the risk the investment bankers are trying to assess is: Does management know what it is doing with growth? Are they out there? Do they have a good story to tell or not?” Cary explains. “Or are they running willy-nilly and not doing something?”

If past performance is any indication, the $5 million the bank received is being put to good use. The amount has increased MidCarolina’s capital base to $16 million, up from $11 million. As a result, the bank will be able to leverage the proceeds about 12 times over, allowing it to eventually boost its asset base to $240 million, up from $170 million.

With the fresh capital, MidCarolina’s legal lending limit for each customer also rose, allowing Cary to immediately call in $3.5 million worth of loans previously farmed out to other banks to meet lending limit requirements. That alone allows him to cover the monthly cost of the trust preferreds, about $13,000. The rest of the proceeds will be used to generate profit.

For the time being, MidCarolina is investing the remaining $2.5 million in bonds before making more loans. In all, Cary predicts the new capital will increase earnings per share without having to rely on a second issuance. The bank also avoids watering down its shareholder base. “We did not want to dilute our shareholders,” Cary says.

Fairport Savings Bank

Though the advantage seems obvious to some institutions, there are plenty of banks out there still mulling over trust preferreds. Fairport Savings Bank will soon map out plans for creating a holding company in its fiscal year 2004, which begins next July. The move will allow it to issue trust preferreds down the road.

Fairport, based in Fairport, New York, is facing increasing competition from bigger banks such as Charter One Financial Corp., HSBC Bank USA, and neighboring credit unions. Along with its deposit growth, the market presents Fairport with a particular urgency to embark on a stronger growth path. CEO Gavenda says the bank needs to expand in order to have a future: “It is critical to grow. We need to do business in markets that are contiguous to us.”

While the economy in upstate New York has been hit with factory closings typical of the Rust Belt, banks are benefiting from the inflow of deposits as investors seek safer havens. Says Fred Price of Sandler O’Neill: “Some of the $100 million to $300 million banks have been hit with growth they really didn’t expect. And that growth is causing them now to look at trust preferreds.”

The costs of expansion for Fairport will add up: $1.3 million for the first branch, and $1 million for each additional one. Its operation center will cost $500,000. Gavenda estimates issuing trust preferreds will become imperative after the opening of the second or third branch, as the expenses will pull down the bank’s core capitalu00e2u20ac”now over 12%. Gavenda says the board won’t want to take the ratio below 8%. “Trust preferreds are a viable route,” he says.

California Independent Bancorp

Some banks have used trust preferreds to increase control of the shareholder base. California Independent Bancorp, a $339 million bank based in Yuba City, California, issued $10 million in trust preferreds through a pooling led by Sandler O’Neill last October. A portion of the proceeds are being used to fund a stock repurchase program it started in November. Operating out of nine branches in the Sacremento Valley under its subsidiary Feather River State Bank, the holding company has used part of its issuance to help fund a Dutch auction to buy 200,000 shares of outstanding common stock, within a range of $22 to $25 a share. That amounts to 9% of its shares, with 2.2 million shares outstanding, not a small feat.

To no surprise, John Jalevich, president and chief executive officer, says the buyback could help boost earnings per share and return on equity. “The main goal is to create shareholder value,” Jalevich says. The rest of the proceeds may be used for acquisitions of branches or banks, he notes. “Until we find a strategic partner, if we dou00e2u20ac”we feel we can invest those funds so we can neutralize the cost of the issue itself.”

Despite all the advantages, there are some things to consider before jumping into the market. First, trust preferreds still cost money. “It does require cash service, whereas equity does not,” reminds Downing of UCBH.

Potential issuers also need to create a holding company to issue the trust preferreds, and qualification is not a given.

MidCarolina, while it didn’t autoqualify, had a sound operating history and solid margins that made it an easy sell to the underwriters. Those banks without a strong record of profitability will be rejected by the rating agencies. And banks on the cusp of qualifying may be bumped at the last minute because there are too many applicants for a particular pool.

“Often they cut back the non-autoqualifiers because they have lower credit scores,” says Choate of Ryan Beck.

Still, for community banks, the advantages of using trust preferreds outweigh the downside, especially against the backdrop of a competitive environment. “It levels the playing field,” says Peter Wirth, an executive vice president and an associate director of investment banking at Keefe. “It’s a way for smaller banks to increase their capital and their ability to continue to provide credit to communities.” |BD|