Trust-Preferred Securities: Leveraging the Bank’s Assets

When Atlanta-based Main Street Banks acquired another bank in northern Georgia last December, it naturally had to pay the piper. If it had made this acquisition a few years ago, Main Street probably would have funded its $96 million purchase of First Colony Bancshares entirely with stock. But equity capital is expensive nowadays compared to cash, so Chief Financial Officer Bob McDermott came up with another funding solution instead: He paid $51 million of the purchase price in stock, and $45 million in cash-funded with an issue of trust-preferred stock.

The flexibility of trust preferred-technically a debt instrument that is treated as equity for regulatory capital purposes-is well illustrated by the Main Street example. The First Colony acquisition had squeezed Main Street’s capital ratios, and according to McDermott, “We always want to be a well-capitalized bank.” The bank operates in some of the fastest-growing communities in the country, so it needs a strong balance sheet to finance its loan growth. And even though the trading value-and therefore the purchasing power-of Main Street’s stock had risen impressively through the first six months of 2003, it was still a more expensive currency than long-term debt, where interest rates have plummeted to the lowest rates seen in several decades.

Issuing trust preferred allowed Main Street to kill two birds with one stone: It strengthened the bank’s Tier 1 capital level while also bringing down the total cost of the First Colony acquisition. It would have been even cheaper for McDermott to sell subordinate debt, but that doesn’t qualify as Tier 1 capital, and it can’t be bought back for 10 years. His trust-preferred issuance, underwritten by a unit of SunTrust Banks, carries a variable rate based on the London Interbank Offered Rate (LIBOR) plus 325 basis points and can be called in five years. Not only that, but Main Street may also deduct the dividend payments from its taxes.

“Cash is so inexpensive right now, this made the price a lot more bearable for the bank,” says McDermott. “Trust preferred is a pretty cheap and efficient way to fund an acquisition.”

There may not be a better time to issue trust-preferred securities than today, given the sharp decline in long-term interest rates just in the last year. For example, Bank of America Corp. raised a total of $1.35 billion through two trust-preferred issues last year-first in January and again in August-paying a fixed rate of 7% each time. When it returned to the market this April to sell an additional $350 million in trust preferred, it paid a fixed rate of 5.875%-yielding a significant savings. According to SNL Financial, 27 banks issued trust-preferred securities, totaling $5.4 billion in 2002. Underwriting activity remained close to that pace through the first four months of 2003, when there were seven deals totaling $2.6 billion through April-including a whopping $1 billion issue by Citigroup in February.

And yet it seems counterintuitive for banks to be raising capital when top-line growth throughout the industry is challenged, acquisition activity is down, and many institutions are finding they are already overcapitalized. “I think you’d be hard pressed to find a commercial bank today that doesn’t think this is a good thing,” says Fred Price, a principal at Sandler O’Neill & Partners. “The real issue is, do I need the capital today?”

In the banking industry, trust-preferred securities owe their popularity to a decision by the Federal Reserve Board in 1996 that they could qualify as Tier 1 capital, up to a maximum of 25%. Because they are not classified as common equity, the instruments are not included in the calculation of a bank’s earnings per share or return on equity, which means they can be used to boost regulatory capital without diluting common shareholders’ stock. And unlike preferred stock, their dividends-which are considered to be an interest payment-are tax deductible.

An extensive trust-preferred market has developed during the past six years, giving large banks a wide choice of underwriters to use. And the development of trust-preferred pools-Salomon Smith Barney did the first one in 1999-has also enabled a significant number of smaller community banks to issue the securities. The pool market has been dominated by Sandler and Keefe Bruyette & Woods, although Credit Suisse First Boston, Bear Stearns & Co., and Salomon have organized them as well. “Until the advent of the pool, it had been difficult for small banks to take advantage of this,” says Peter Wirth, a managing director at KBW.

Although assessments vary slightly from one underwriter to another, the general consensus is that issuing banks should have at least $2 billion in assets before they consider going into the market as a sole issuer. Banks smaller than this aren’t likely to be raising enough money to make the transaction cost effective.

In a pooled structure, the participating banks sell their trust-preferred securities to a trust that has been set up by an investment bank, which is the same structure used by a single issuer. Investors receive long-term notes-generally with 30-year maturities and five- or 10-year call options-that have been collateralized by the trust-preferred securities and have received an investment-grade rating by rating agencies such as Moody’s Investors Service and Standard & Poor’s Corp. Participants in the pool share equally in the expense and the proceeds. Most pools range in size between $2 million and $30 million, although they can be much larger.

To qualify, banks need at least five years’ operating experience and approximately 10% Tier 1 capital. Banks generally need to have at last $100 million in assets to get into a pool, although this size cutoff seems to be somewhat flexible based on the financial strength of the institution.

As securities go, trust preferreds may have more uses than a Swiss army knife. They can be used to finance acquisitions, as in the case of Main Street Banks. They also can be used to fund a stock buyback program, which has the happy effect of boosting a bank’s ROE and earnings per share without weakening its overall capital structure or reducing its shareholder base enough to qualify as an S corporation, which is limited to 75 shareholders or less.

And the proceeds can be used to support a bank’s asset growth-assuming, of course, it can find a meaningful supply of earning assets to put on the balance sheet. But even here some banks like to keep a little extra capital on hand, just in case. James B. Gardner, a senior managing director at Dallas-based Samco Capital Corp., was instrumental in setting up the Regional Advisors Alliance, a cooperative effort between Bear, Stearns and nine regional investment banking firms that puts together trust-preferred pools for community banks. Gardner says one participant in a recent RAA pool wanted to raise some capital “as insurance, just in case [the company] grew real fast.”

Underwriters report there is still considerable interest among smaller banks to participate in the various trust-preferred pools. “I think they have become more competitive and more consistent with their terms,” says Mark J. Ross, a managing director at St. Louis-based Stifel Nicolaus & Co., which has brought a number of single issuers to market in the last 18 months.

Indeed, the entire trust-preferred market has become very mature-which is to say both efficient and liquid, with no window pressure. And that’s good news for bank issuers of all size, because you never know when a little trust-preferred capital might come in handy.

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