Fear of the Unknown

When Richmond, California-based Mechanics Bank announced in early January that it was accepting $60 million in government capital, board members thought they had a pretty good grasp on the pros and cons of taking the money.

Two months of due diligence had exposed some serious questions, to be sure, but getting capital from the Treasury Department’s Troubled Asset Relief Program (TARP) looked like a relatively cheap and easy way to shore up the balance sheet and provide greater operating flexibility in a shaky economy. That, directors concluded, was worth exchanging some independence for.

“We don’t know how deep and dark this recession will be … this was a way to shore up the unknown,” explains Diane Daiss Felton, the board’s vice chairman. “The thinking was, ‘If most of our competitors are taking the money, would we be silly not to?’ “

The decision vaulted $2.9 billion Mechanics into the ranks of some 500 banks and thrifts that through the end of March had agreed to accept nearly $200 billion through TARP’s Capital Purchase Program. Three weeks later, however, Mechanics pulled an about-face, becoming perhaps the first bank in the country to rescind its public acceptance of TARP money before it had formally signed on.

So what changed? The truth is, directors never were able to get fully comfortable with a contract that allows the government to effectively dictate terms on everything from capital management to loan and compensation strategy. The company has a long tradition of paying a fifth dividend at the end of the year, for instance, and it wasn’t clear if that would be allowed to continue.

As additional guidance from regulators and Congress emerged indicating the government’s willingness to use a heavy hand, support began to crumble. When the 105-year-old company’s management recommended the board reconsider its original decision, the sentiment shifted rapidly in favor of rescinding the deal.

“It wasn’t one thing, it was a plethora of items: the threat to our independence-perhaps having a government observer in the boardroom, perhaps being pressured to make loans that we know aren’t correct,” says Felton, a 28-year Mechanics director. “We’re fiercely independent. To take on a contract that could limit that independence was counterintuitive.”

Don’t be surprised to see other banks-perhaps many others-following Mechanics’ lead in flip-flopping on their decisions to accept TARP money. Since February, several mid-sized institutions, including Iberiabank Corp. in Lafayette, Louisiana, and Minneapolis-based TCF Financial Corp., have reversed course and announced plans to return the government capital. Big players, including Wells Fargo & Co., U.S. Bancorp and Goldman Sachs Group, have indicated their desires to do the same as soon as possible.

Gaining approval for the program is akin to receiving the Good Housekeeping seal of approval: an endorsement from the Treasury and primary regulators that a bank’s operations are both viable enough and important enough to the economy to merit government support. That could prove vital down the road, when banks seek private capital, and in theory should be a potential marketing tool-provided the public and Congress ever grasp how the program works. Aside from the occasional ailing giant deemed too big to fail, only healthy banks -those with CAMELS 1 or 2 ratings-are supposed to receive the money.

Even so, the money comes with a big catch: Having the government as a shareholder. The capital injections take the form of sales of nonvoting preferred shares to the Treasury. The shares pay the government a 5% dividend in each of the first five years, before rising to 9%. The amount of capital typically falls between 1% and 3% of risk-weighted assets, but cannot exceed $25 billion-at least initially.

The government also gets warrants to purchase common shares out of the deal, equal to 15% of its total investment, with a strike price equal to the average share price for the 20 days preceding the investment. The rules are pretty much the same for smaller, Subchapter S banking companies. Either way, the idea is for banks to make use of the capital now, then buy the government out of its investment once the economy improves.

We’re clearly in uncharted waters here, part of history in the making. Large banks already have been all but nationalized, and having broad government investment in such a wide swath of the banking sector “is a generational event, much like the Great Depression,” says Camden Fine, CEO of the Independent Community Bankers of America, a Washington, D.C.-based trade group. “Doors have been opened here that no one wanted opened. The industry has lost a certain amount of its independence.”

That’s putting loads more pressure on directors. Many boards already are busy confronting the effects of deteriorating loan portfolios and a nasty recession. They must stay on top of increasing compliance and governance responsibilities, and still have basic strategy to hammer out. And now, there’s TARP. The acronym itself has become synonymous-fairly or not-with the notion of bankers who caused the economy’s problems getting special treatment, and elicits strong, mostly negative, emotions on Main Street. Recent scandals involving bonuses at some of the most-troubled TARP recipients have only added fuel to the fire.

The outrage resonates in many bank boardrooms, and is complicated by a palpable sense of uncertainty about what the future holds. When it comes to TARP, there are so many variables-about the economy and the governmental response-the only sure thing is that it’s subject to change.

“Making a reasoned decision is very difficult. Board members don’t have all the facts. They don’t know all the rules,” says John Freechack, chairman of the financial institutions group at Barack Ferrazzano, a Chicago law firm. “They’re trying to react in a proper corporate governance context. But it’s very difficult and complex … very stressful.”

Bank boards have at least two basic TARP-related tasks to confront. The first is deciding if taking the money makes sense for their institutions. The second involves navigating a course through a turbulent environment that will be influenced by government capital, regardless of whether an individual bank takes the money or not. As Fine notes, TARP is “a game changer for everybody.”

On a purely financial basis, the capital looks like a relative bargain given the lack of affordable private investment money available. “From a quantifiable accretion-dilution analysis, the government money is still the cheapest available Tier 1 capital,” says Allen Laufenberg, a managing director at Stifel Nicolaus, the St. Louis investment bank. He says private equity and institutional investors in this environment would likely seek at least a 9% or 10% coupon and a significant share-price discount for a similar investment.

For the board of $9.2 billion First Niagara Financial Group in Lockport, New York, “taking the money was a no-brainer,” says CEO and director John Koelmel. First Niagara’s markets are experiencing loads of dislocation as bigger banks falter, and Koelmel senses an opportunity to gain market share. The company raised $115 million in an October public offering, and added another $184 million in TARP capital a month later. “Our intention is to leverage that capital up at 8- or 10-to-1,” Koelmel says, which should add as much as $2 billion in loans to the balance sheet.

The board of SVB Financial Group, parent of $9.5 billion Silicon Valley Bank, has something similar in mind. It signed off on the sale of $235 million worth of preferred shares to the Treasury after a shutdown of public markets thwarted its plans to raise private capital. The Santa Clara, California-based lender saw deposits grow by 17% in 2008. “We wanted to make sure the balance sheet was strong enough to accommodate growth and any changes in the environment, and there weren’t any other alternatives,” says Ken Wilcox, SVB’s CEO and a director.

For others, taking the capital is more of a defensive move. Bank balance sheets everywhere are taking losses, and no one can claim to know how bad things will get. Through the end of March, 45 banks and thrifts had failed since the beginning of 2008. Analysts say the tally could eventually run into the hundreds.

Customers are nervous, and smart ones appreciate what having extra capital can do for a bank. “At the end of the day, customers care about if the bank will be around a year from now,” Laufenberg says. “By accepting TARP money, your viability should no longer be in question.”

For many directors, a reasonable argument can be made that taking TARP money in this environment is a smart fiduciary move. “The ultimate risk for a director comes if the bank fails. The [Federal Deposit Insurance Corp.] comes in as a receiver and has the option to sue you,” says David Baris, executive director of the American Association of Bank Directors and a managing partner at Kennedy & Baris LLP, a Bethesda, Maryland law firm. “If you think you might need the money to stay afloat, then everything else becomes secondary.”

Indeed, for some banks, not qualifying for TARP has proven to be the proverbial final nail in the coffin. At least one institution-$431 million National Bank of Commerce in Berkeley, Illinois-sued Treasury and regulatory agencies after its bid for participation was turned down. The company lost the case, and failed in January.

Directors at MidSouth Bancorp, a $937 million company in Lafayette, Louisiana, spent three weeks mulling whether or not to take $20 million in TARP funds before concluding it was best for the company. The board “is worried about survival and how we get out of these problems,” says Rusty Cloutier, MidSouth’s CEO and a director. While directors were uneasy about jumping into bed with the government, “In the end it was, ‘We’d better take the money, because we have no idea how bad things will get.’ ”

Later on, TARP recipients could have an advantage raising private money. “If a bank needs to raise money from private-equity sources in 2009, one of the first questions will be: Did you apply and/or qualify for TARP?” Laufenberg says. Banks that didn’t apply will need to justify the move with stronger-than-average loan-quality figures and managements. “Private equity consistently tells us that they do not want to be an investor in a bank that couldn’t qualify for government TARP,” he explains.

Regulatory agencies, too, have been encouraging banks to take the money, and staying in their good graces seems prudent at a time like this. It’s possible that turning down the money could come back to bite an institution.

If most of your bank’s peers take the money and you don’t, the institution will suddenly appear less “well capitalized,” Laufenberg explains. “If you have some surprises on your loan portfolio and you’re below your peers in terms of capital, the regulators might start putting a little pressure on you to raise more capital.”

Some believe that a bank with TARP money could even garner more favorable treatment in exams, though there’s no real evidence to support the notion. “If the government will suffer consequences as an investor if [examiners] come down too hard on a bank, will that make their exams easier?” asks Ron Glancz, chairman of the financial services group at law firm Venable LLC in Washington, D.C.

These are compelling arguments. In times of stress, it’s tough to argue with a package that carries an implicit survival guarantee and curries favor with regulators. Even so, some 20% of publicly traded banks have opted not to apply for the money, according to an analysis by SNL Financial in Charlottesville, Virginia. An unspecified number have applied, been accepted, and then turned it down.

With new provisions that allow banks to buy their way out of the program without raising new capital-a requirement of the initial TARP plan-many more that already have banked the money are considering returning it.

At its core, the anti-TARP argument is colored by a profound distrust of the government. Many directors, hard-core capitalists at heart, have philosophical problems with government ownership. They’re disgusted by the big-bank bailouts, and don’t believe Congress can resist doing something bad with its newfound powers.

If your bank received TARP money, “you have a duty to the government now, too,” Glancz says. “The government is an investor, and you need to make sure your business decisions serve the interests of the government, even if they’re different from those of ordinary shareholders. That’s scary.”

Cloutier says several longtime MidSouth directors who lived through bad times in the oil patch in the 1980s warned the board “not to trust the government. Whatever they tell you today will change tomorrow.” The day after February’s stimulus package was passed, the board met to discuss giving the money back. “All the directors around the room apologized to those guys. They said, ‘You were right. We were trying to do the right thing, but the government can’t be trusted,’” Cloutier says. At the end of March, no decision had been reached.

While the TARP stakes typically aren’t large, the contract is so open-ended some say you might as well hand over the keys to the Treasury. It gives government officials the ability to call the shots on a wide variety of operational issues and allows them to change terms and requirements in virtually any way and at virtually any time. In the worst case, a bank could be drafted into service for political initiatives that don’t make sense for either the institution or its shareholders. “The deal is not a deal at all,” says William Isaac, former chairman of the Federal Deposit Insurance Corp. and now chairman of the Secura Group, a Vienna, Virginia-based consulting firm. Adds Glancz: “As a director, it’s hard to exercise your fiduciary duty to shareholders when you don’t know what you’re agreeing to” in such an important contract.

The boards of some TARP recipients are watching Congress warily. “The government can’t afford to screw this up, and we’re a willing participant,” Koelmel says. “But our directors are anxious. They were skeptical about dealing with the government from the get-go. And what we’ve seen so far in terms of political rhetoric, noise, and chatter hasn’t done anything to ease the anxiety.

“The face cost of the TARP money is high single digits, but the ability to run your business the way you want is priceless,” Koelmel adds. “If we’re going to have the government telling us how to do things, we will absolutely look at repaying the money.”

Already, TARP banks face stiff limits on executive compensation and cannot raise their dividends or buy back shares without the Treasury’s permission. Such conditions could prove a competitive disadvantage. The pay caps, for instance, could leave an institution vulnerable to losing its leadership to a non-TARP rival down the street.

“You can have a CEO who has been conservative and done a good job, and the bank has qualified for TARP because of it. Now, he might have to agree to see his salary cut and lose his incentives,” Freechack explains. “It flies in the face of everything governance experts have been talking about for the past decade.”

While many banks are cutting dividends now, most board members would like the flexibility to reinstate them without first getting government permission. Bans on repurchasing shares, meanwhile, are a big issue for shareholders of some thinly traded banks who rely on the institution for stock liquidity.

CEOs of TARP recipients, even those of small, private banks, also should prepare to have their pay levels-along with how the figures were determined-go public. “Even if you’re not a public company, if you’ve taken TARP money, you need to make compensation disclosures,” Baris says.

TARP recipients also face potential roadblocks when it comes to making acquisitions-a prime consideration at a time when many good-but-struggling banks are likely to go on the block at significant discounts.

Carl Chaney, CEO and a director at Hancock Holding Co. in Gulfport, Mississippi, figures he would have qualified for $167 million in TARP money, but never applied. The $7.4 billion company has branches in four southern states. “We’re going to have untold opportunities to do failed-bank acquisitions in our markets over the next 18 months,” Chaney says.

Initially, it appeared TARP money could be used for acquisitions. That has changed, and TARP requires that new capital must first be used to buy back the government’s shares. “If I raised money, I’d have to pay off $167 million before I could even get to the point of funding an acquisition,” Chaney explains.

Chaney says his board also was frightened by public perceptions-driven by congressional bombast and inaccurate media reports-that TARP capital is “bailout” money being given to banks that otherwise would go under. “The general public believes that TARP money is meant for troubled banks,” he says. “People think it’s a gift-a grant that doesn’t have to be paid back-as opposed to a capital infusion that must be paid back with interest.” As a non-TARP recipient, “those perceptions have worked to our benefit.”

The big banks that paid out year-end bonuses amid record investor losses only tarnished the industry’s-and program’s-image more. In a February address to Congress, President Obama acknowledged the obvious. “I know how unpopular it is to be seen as helping banks right now, especially when everyone is suffering in part from their bad decisions,” Obama said, adding that he was “infuriated by the mismanagement and results” of the TARP program.

When CEO Steve Buster announced at a town hall meeting that Mechanics had changed its mind and was turning down the money, “there was spontaneous applause,” Felton recalls. “We’ve gotten calls to our call center, e-mails, and letters from people congratulating us for standing up to Congress. We’ve had people bring us large accounts because we turned down TARP money.”

For all that, the biggest fears center on Congress’s power to make changes as it goes along. One small example is a requirement, instituted in February, that TARP recipients entertain nonbinding shareholder advisory votes on executive compensation.

Bank boards can make their best guesses, but no one can accurately predict what comes next. The economy could stage a miraculous recovery, rendering concerns about government control moot. Or we could be in for a long, painful recession-one fueled by plunging real estate values and rising foreclosure rates.

The Obama administration’s “stress tests” of large banks are based on a worst-case scenario that includes a further 22% drop in housing prices and a 3.3% decline in GDP in 2009. Some believe the scenario isn’t dire enough. Either way, it’s not far-fetched to think that lawmakers-looking for ways to revive the economy and justify the government’s capital injections-could begin dictating loan types and terms to TARP recipients.

Cynics, noting that banking already is heavily regulated, say concerns are likely overblown. “I’ve been under government restrictions my whole life,” MidSouth’s Cloutier says. “I don’t think a regulator will walk into one bank with one set of requirements and then go to another bank and say something totally different.”

But Fred Cannon, a San Francisco-based analyst for Keefe Bruyette & Woods, says TARP recipients will likely need to do more heavy lifting to help along the recovery. TARP provides for a government “group” to oversee the preferred shares and warrants “in the best interests of the taxpayer.” That hasn’t happened yet, but is expected to ramp up in coming months.

With the news filled with reports of big pay packages, incentive trips to exotic locales, and banks purportedly hoarding capital instead of lending it, Cannon says it wouldn’t be surprising to see TARP banks “being ordered to make 3% mortgages,” or something similar, if the economy continues to struggle. “It would be a bad deal for shareholders, but it would help the economy,” he explains.

If yours is a TARP bank, “you now have a major investor who has different goals [from maximizing shareholder value],” Cannon continues. “They have a social agenda. They want system stability. With TARP they have the power to enforce it.”

There’s chatter about possible government interference in boardroom affairs. At least one financial institution with government money-troubled insurer AIG-has gone public with news that an “observer” from the Federal Reserve has been sitting in on board and committee meetings. A big March shake-up on Citigroup’s board came after Treasury officials reportedly pressured new Chairman Richard Parsons to oust some long time directors and replace them with a cadre of financial and risk management experts.

There’s also plenty of worry about what the government might do with the preferred shares and warrants. Ideally, banks will simply buy them back. But it’s also possible that the government could sell the warrants to private investors to make money and get political cover.

It’s conceivable that TARP’s restrictions could hold recipients down when the economy recovers, giving those who didn’t take the money a strategic and competitive advantage that makes them more attractive to investors.

Big banks, meanwhile, are concerned that the results of TARP-related stress tests, due at the end of April, could expose weaknesses that weren’t part of the original bargain. “If you don’t pass that stress test, the whole world will know about it,” says one jittery banker. “You’ll have a big bull’s-eye painted on your forehead.” (A positive result on the test, conversely, could be very good news.) Banks that fail the test will be required to raise additional private money and will then be eligible for more government capital.

Terms the second time through will be “a lot more restrictive,” says Robert Clarke, senior partner at Bracewell & Giuliani in Houston and a former comptroller of the currency. The coupon will be 9%, not 5%, and “you can’t repurchase shares, you can’t pay dividends of more than a penny per share, you can’t acquire healthy banks, you have to commit to participate in mortgage foreclosure mitigation programs, you can’t pay someone more than $500,000 in total compensation, you have to give shareholders a say on pay,” Clarke says, ticking off the requirements. “It’s a lot tougher than the original TARP program.”

In short, having TARP money is anything but a panacea-bad medicine that many recipients take because they feel they must. To protect themselves processwise, board members should exercise high levels of diligence, applying the basics of the duty of care-such things as hiring good outside advisers, asking smart questions, and attending meetings-to their TARP deliberations.

The take-it-or-not decision depends largely on an institution’s circumstances, meaning there’s no one “right” answer. Mechanics’ directors read every press clipping and government pronouncement they could get their hands on, hired lawyers, and quizzed investment bankers and regulators-all to enhance their understanding-and still wound up changing their minds.

“We did our homework, studied the issues, and kept abreast of changes at every moment along the way,” Felton says. Her advice: “Don’t take your information from one source. Get recommendations from experts, management, shareholders, and the community.”

Regardless of the choice, TARP as a shareholder issue carries enough oomph that “from a fiduciary and corporate governance perspective, boards have to be very, very careful to document the reasons for why they are or are not taking the TARP funds, or why they are sending them back,” Freechack says.

Directors should think carefully about these reasons. More than one board, for instance, has discussed not pursuing TARP money because of the executive compensation limits. “If you’re not taking the capital simply because your CEO can’t make more money, the board could be criticized for that -especially if it turns out the organization needs the funds,” Freechack adds.

Boards that have gained TARP approval but haven’t yet signed are pushing for extensions, hoping time will provide greater clarity into the government’s moves. For those that already have the capital, it’s time to be proactive. “You need a plan for what you’re going to do with the money,” Clarke says, even if it’s as simple as putting it into some fixed-income investments.

You also want an exit strategy-one that can be executed quickly if it makes sense when the markets recover or the terms get too arduous. Banks that buy out the government’s preferred stakes by the end of 2009 will see the warrant count slashed in half, to 7.5% of the total TARP allocation. If the capital markets loosen up by then-a big if-Laufenberg expects a rush for the door, creating “a supply-demand imbalance” that tilts pricing sharply in favor of investors.

Boards also are learning they must be proactive about disclosures. Colonial BancGroup, a $26 billion lender in Montgomery, Alabama, faces a shareholder lawsuit because it failed to reveal that the $550 million in TARP funds it qualified for were contingent on raising $300 million in equity on its own first.

New rules require monthly updates on how the money is being used. While it’s difficult to draw a straight line between new capital and loans, some already have begun giving it a shot. In February, First Niagara issued a press release showing that it originated $815 million in new loans and lines of credit during the fourth quarter, up 18% from the third quarter.

“We’re trying to portray, summarize, document, and substantiate what we’re doing,” Koelmel says. “If someone wants to try to follow the money, we’re doing our best to help them out.”

Beyond that, smart board members are ensuring their banks lie low and try not to make headlines. “Don’t go buy a new airplane or go crazy on bonuses,” Isaac advises. “You don’t want to draw attention to yourselves.” They’re also relying on their colleagues for moral support. “You get to know each other on a more intimate level when you’re working through these kinds of issues,” confides one director.

There are, of course, alternatives to TARP, even for borderline banks. A board could order management to shrink the balance sheet, cut staff, or sell off noncore operations. The problem is, it would be painful for employees and customers, and could amount to setting the table for a sale. At a time of national crisis, when banks need to lead an economic recovery, it’s also not “the patriotic thing” to do, Cloutier says.

Felton says Mechanics directors are confident that their about-face was the right decision. Even so, some nagging doubts linger. “Are we putting our future at risk here if things get really terrible? If the capital could have seen us through, how would that stand with our fiduciary responsibility?” she asks. It’s a good question, and one that only time will be able to adequately answer.