The U.S. Treasury Department’s Troubled Asset Relief Program was either the saving grace of the global economy or a mismanaged handout rewarding failure at the largest banks and automobile companies, depending on the person talking. Some think it was both. The only group lost in the debate is the more than 340 community banks still in the program like a hangover that won’t go away.
While the big money center banks have paid off their government capital and the best of them are making record profits, most of the remaining TARP refugees are community banks and thrifts that have much less attractive prospects. Many of these institutions-although not all-have difficulty attracting investors or capital to pay off the government’s money. One-third of them have formal enforcement actions from their regulators. Nearly half have missed dividend payments to the Treasury. Overall, they have higher levels of non-performing assets and their stocks trade at a discount compared to banks as a whole. And at least sixteen TARP banks have already failed.
One hopeful exit strategy for these smaller TARP banks was supposed to be the Congressionally-created Small Business Lending Fund. TARP banks could refinance out of TARP into the program and other, non-TARP banks could also apply, getting low-cost capital in exchange for increasing their lending to small businesses. But the program was restricted to healthy banks and thrifts and only 137 TARP institutions were approved, while 178 that applied were rejected.
While an argument can be made that TARP stabilized the global financial system during the 2008 financial crisis, one of the unresolved questions is what happens to the community banks still wrapped up in it, nearly four years after they took the money. Some of them are in better shape than others and won’t have any problems paying it back or raising new capital. If market values improve for community banks, even more will be in a good position to repay. Others may find their stock sold off at auction to investors, or perhaps even be forced into an unattractive sale. For both kinds of banks, the clock is ticking.
Five years after receiving the money, TARP banks in what is called the Capital Purchase Program will see the dividend rate on the preferred stock rise from 5 percent to 9 percent annually, so that most will start seeing increases in payments due in late 2013 or early 2014. The increasing dividends will be more of a problem for some than others.
The Special Inspector General for TARP, Christy Romero, is concerned that when dividends increase, many of these banks will remain in TARP but won’t be able to exit the program, and also won’t be able to afford the new dividend amounts.
“I’ve not seen any plan at all, any comprehensive plan that goes bank by bank that details how Treasury and the regulators are going to help these banks get out of TARP,” she says.
Former U.S. Sen. Ted Kaufman (D-Delaware), who was the chairman of the Congressional Oversight Panel for TARP, says there hasn’t been much emphasis on community banks.
“It was great for the big banks but it really wasn’t great for the local banks,” he says. Not only did the one-size-fits-all approach end up benefiting the larger banks that have successfully exited TARP, but their growth and success has made it tougher for the smaller banks to compete with the larger banks, he says.
Timothy Massad, assistant secretary for financial stability at Treasury, defends the program. “The whole concept that [community banks] could be worse off because they got capital is particularly backward,” he says. “The capital helped them weather the storm.”
And what is Treasury’s plan? Allow banks to repay the money during the next 12 to 18 months, or for those who can’t repay, restructure the investments or sell the stock off to investors using auctions.
Massad concedes that most of the banks remaining in TARP probably will not be able to pay off the money in full. He said many have difficulty accessing the capital markets for funding to pay off the money and continue to struggle with problem loans.
Already, Treasury has gotten started with its divestiture plan. It has restructured at least 20 bank investments, usually in connection with a merger or plan to raise new capital. In March, it launched its first auctions of remaining TARP bank stock, selling preferred stock in six TARP banks at discounts to par value ranging from 6 to 18 percent.
“But we have already estimated that the value of these investments is less than par in our budget projections, and we’ll only sell above a pre-set reserve price in order to best protect taxpayer value,” Massad wrote in a blog post.
In June, the U.S. Treasury sent letters to about 200 banks saying it was considering pooling their stock and selling it at auction, according to SNL Financial LC.
Some banks will be able to use the auction proces to buy back the preferred stock at a discount, or arrange for a restructuring to repay the Treasury at a discount, says Robert Klingler, a bank attorney at Bryan Cave LLP in Atlanta who advises TARP banks.
A restructuring can work like this: You’ve found an investor who wants to buy the bank’s stock at 80 percent of book value. You go to the Treasury and propose that the bank redeem the shares from Treasury at 80 percent of book value, the same as the private investor was willing to pay.
Klingler estimates that one-third of TARP banks don’t have the ability to redeem the stock, another one-third can but see no reason to, and the final third are somewhere in between. They could partially repay TARP but also need a little help, he says.
Treasury officials have been steadfast so far in refusing to negotiate discounts to par for banks or thrifts redeeming their stock, but if a bank or thrift wants to buy back its own stock at an auction or restructure its capital, that’s the opportunity to receive a discount, he says.
Klingler advises banks to “pick up the phone and talk to Treasury and let them know what your plan is. They might not want to go along with your plan, but you don’t want them to screw up your plan because they didn’t know about it,” he says.
Wilshire Bancorp, the holding company for Wilshire State Bank in Los Angeles, bought back most of its TARP stock, 60,000 shares, at a Treasury modified Dutch auction for 94 cents on the dollar. The repurchase at a 5.6 percent discount gave the bank a one-time capital adjustment of $2.3 million. The bank also saved $3 million per year in dividends by doing so.
“It was a very positive experience,” says Alex Ko, the executive vice president and chief financial officer for Wilshire, a $2.7-billion asset institution that caters to the Korean-American community around Los Angeles.
Wilshire was in a good position to repay TARP. Even after the repurchase, its risk-based capital ratio was in excess of 19 percent. Ko says the banking company’s capital level was strengthened by improving earnings, as the bank got rid of lots of bad loans in late 2010 and early 2011. The bank now has a return on average equity of 21 percent. “Cleaning up those problem loans aggressively meant we were in a better position for growth and to strengthen our core earnings,” he says.
Ko says he had discussions with officials at investment bank Houlihan Lokey, which is advising the Treasury on the TARP auctions, about what was best for the bank and the Treasury, and the parties agreed to the auction.
D.A. Davidson & Co. stock analyst Gary Tenner, who follows Wilshire, says the auction raised some eyebrows in the investment community because Wilshire was in good financial condition but still got a discount to par value. He says many believe Treasury is eager to unwind itself of its TARP holdings during a presidential election year and that may impact the willingness of Treasury to take discounts.
“It wasn’t a surprise that they were able to pay back TARP,” Tenner says. “It’s a question why they even participated in the auction.”
Massad says two banks in that initial auction received approval from regulators to bid on their own stock, adding that allowing a bank to bid on its own shares increases participation in the auction.
“If a bank does get permission to bid on its shares, it’s only going to win if it bids more than anybody else,” he says.
Private investors also will be looking for discounts through the auction process. But what will it mean for the banks if their stock ends up in private hands? Although some of the TARP restrictions go away when the money is transferred to private hands, such as executive compensation restrictions, private investors also might end up being activist investors who put pressure on the bank to do their bidding.
“It will probably be owned by an entity less friendly than the Treasury,” says Steven Hovde, president and CEO of investment bank The Hovde Group, which specializes in financial institutions. “The Treasury did it for an economic reason, for the broader economy. What’s to stop an activist investor from buying [TARP stock] at a discount and then putting pressure on the banks to repay it?”
Chris Marinac, managing principal and director of research at broker/dealer FIG Partners LLC, is more upbeat. “It’s not the end of the world if Treasury sells your stock,” he says.
Marinac thinks 2014 will be the trigger that will cause banks to scramble to repay TARP before dividends rise, at which point, he predicts bank valuations will have improved and it will be easier for banks to raise common equity at tangible book value.
“My near term prognosis is there are fewer payoffs in 2012, but we do see a lot of strategic thinking in having a late 2013 or early 2014 payoff,” Marinac says. “[The stock] is going to be more expensive than people want at 9 percent.”
If Marinac’s predictions hold true and bank valuations improve, that will be good news for TARP banks. However, access to capital markets has been so tough and some of them have been in such bad condition that their futures are hard to be optimistic about.
Nearly 15 percent of TARP participants have a Texas ratio greater than 100 percent, which is a sign of potential failure and is more than double the rate of all banks and thrifts, according to SNL Financial. TARP banks and thrifts have a median ratio of non-performing assets to total assets of 5 percent, about triple the rate of all banks and thrifts.
They also tend to trade at a discount to book value, at a median of 60 percent for publicly traded TARP participants compared to an industry average of 99 percent as of late May, according to SNL.
Porter Bancorp, a $1.4-billion asset holding company for PBI Bank in Louisville, Kentucky, was trading at about half its tangible book value in mid-May. Its non-performing assets were nearly 10 percent of total assets in the first quarter and it had a consent order as of June 2011 with the Federal Deposit Insurance Corp. and the Kentucky Department of Financial Institutions. Plus, it’s under pressure from an activist investor to get rid of its president and CEO, Maria Bouvette, who has been with the bank for 23 years.
“We think this bank has been mismanaged at every turn,” says Greg Taxin, a managing director at The Clinton Group, a New York hedge fund that bought $5 million of the bank’s stock in 2010 at $10.93 per share. The stock was trading below $2 per share near the end of May. “They were slow to recognize the troubled nature of their loan book, and kept this stuff on their balance sheet as long as they could.”
The bank says it has been working to divest itself of non-performing assets. Bouvette and the bank’s chief financial officer did not return phone calls seeking comment.
Brian Holmes, a principal in the Chicago office of consulting firm McGladrey, says small banks with problem assets have a tough time unloading those assets and taking the capital hit without becoming technically insolvent.
His firm, along with investment bank Raymond James and law firm Barack Ferrazzano, have estimated that banks below $10 billion in assets are going to need to raise $23 billion in capital in the next several years to absorb credit losses, meet higher regulatory capital ratios and refinance out of TARP.
Joshua Siegel, the co-founder of asset management firm StoneCastle Partners LLC, which invests in community banks and manages $4 billion in assets for institutional investors, has put the estimate at closer to $90 billion, including capital that banks will need in order to purchase other institutions in the coming years.
He says small banks have had trouble raising capital because of more than just problem loans. He also attributes the problems to the Bank Holding Company Act, which restricts what percentage of a bank any one entity or person can own before being regulated as a bank holding company or needing certain personal disclosures. Many private equity firms aren’t interested in making small investments to avoid the threshold and wealthy investors don’t like the personal disclosure requirements of the act, Siegel says.
As a result, he expects the pressure on community banks to raise capital will lead to mergers and acquisitions that will gobble up about 800 banks in the coming years.
Catherine Mealor, senior vice president in equity research at investment bank Keefe, Bruyette & Woods, also believes a rise in TARP dividends and the industry’s weakened profitability will prompt increased mergers and acquisitions.
“Banks are slowly realizing they’re not going to have the same profitability as they have had and the best way to get more efficiencies is a merger,” she says. “You also have a lot of board and bank fatigue. At the end of the day, they know a sale is their ultimate fate. It’s just a matter of timing.”
However, she thinks some banks will hold onto the preferred stock even after dividends rise to 9 percent, as some bank executives have said they’ll accommodate the increase just fine. She explains that if your bank is trading at half tangible book value, and raising common equity would dilute shareholders, 9 percent sounds workable.
Healthier banks that still have TARP stock and can afford to get rid of it will most likely go ahead with a divestiture of some type. Park National Corp, the $6.8-billion asset holding company based in Newark, Ohio, redeemed $100 million of TARP shares recently, in part with cash and by selling $30 million in subordinated notes at 7 percent interest.
C. Daniel DeLawder, chairman and CEO of Park National, says the repayment made sense because TARP money was actually more expensive than the debt. Unlike the interest payments on the debt, TARP dividends are not tax-deductible, meaning they have an effective borrowing cost of 7.69 percent after taxes.
Still, DeLawder believes TARP was beneficial for his bank.
“It gave us an insurance policy and a depth of capital,” he says about a bank that stayed profitable throughout the financial crisis and continued paying dividends to shareholders.
DeLawder is among many in the banking industry who think TARP was a success not only for the industry but for the global economy.
“We really could have faced a cascading series of failures around the globe,” he says. “The [Capital Purchase Program] that was created by the Treasury was just brilliant.”
In its full context, TARP was one of many measures taken by the Treasury and the Federal Reserve to inject liquidity into the nation’s financial system and improve confidence. The Treasury has been especially vigilant of late defending the program for banks and saying that it has been profitable for taxpayers. Massad has noted that the Treasury has already locked in a $19 billion positive return for the Treasury. Most of the TARP money has been repaid with interest. The bulk of the losses recorded by the Treasury related to banks in the program were from small business lender CIT Group. Only $11.6 billion remains to be paid as of May.
That means even if Treasury gave away all the remaining stock for free, the bank portion of TARP’s balance sheet, the Capital Purchase Program, would still make money for the Treasury. (The same can’t be said for TARP as a whole, which included losses from automobile companies, AIG and home foreclosure programs, so that the total cost of TARP to taxpayers was estimated at $43 billion as of April, much less than the $356 billion cost previously estimated.)
Often, those who are critical of TARP recognize that it helped shore up the world’s financial health, but still argue that TARP was flawed and has had significant negative consequences. For instance, the Treasury’s repeated assertions that TARP for banks has been a gain for taxpayers is misleading, says Dean Baker, co-director of the Center for Economic and Policy Research.
“We walked into a full-fledged financial crisis where people were paying high prices for liquidity, we lent money at way below market rates, and we got most of it paid back,” he says. He uses the hypothetical example of the government deciding to give everyone mortgages at 2 percent interest. If the government made money with such a program, would that mean it was profitable?
“We could have lent money elsewhere at a much higher interest rate,” he says. “We could have put any conditions we wanted on it.”
Others, including the Special Inspector General for TARP, Christy Romero, have been critical that the program didn’t do enough to help prevent foreclosures, and far fewer homeowners were helped than was originally estimated.
She says that TARP’s legacy is mixed, including the creation of moral hazard, where financial institutions could take on more risk assuming they’ll be bailed out by the government again if their bets go bad. TARP’s legacy also includes the perception that the government would help big banks, but leave homeowners and community banks to struggle.
“TARP is in no way over,” she says. “There are significant legacies that come out of it.”
Economists and politicians will debate for decades whether TARP should have been undertaken, and whether it was done right. One of the smaller, less talked about legacies is the chapter on community banks, whose ending hasn’t been written yet.
“I think TARP was a success in achieving its stated goal of stabilizing the financial system,” says StoneCastle Partners’ Siegel. “Was it a success for community banks? I don’t know if that was ever its goal.”
What the future holds for community banks still stuck in TARP may be as much a mystery to the banks as to the rest of us. Given their significant role in small business lending, the future of those institutions will be very important to a great many people.