Subordinated debt can be an attractive capital option for many banks. Will Brackett, managing director at Performance Trust Capital Partners, breaks down how bankers can think through their approach to using subordinated debt. He recommends that every financial institution take a hard look at its balance sheet and how it could perform under myriad interest rate scenarios. Those banks with strong track records, and little or no existing subordinated debt, are best positioned to fetch better than market pricing in an issuance.
The nationwide pandemic and persistent economic uncertainty hasn’t slowed the growth of Idaho Central Credit Union.
The credit union is located in Chubbuck, Idaho, a town of 15,600 near the southeast corner, and is one of the fastest growing in the nation. It has nearly tripled in size over the last five years, mostly from organic growth, according to an analysis by CEO Advisory Group of the 50 fastest growing credit unions. It also has some of the highest earnings among credit unions — with a return on average assets of 1.6% last year — an enviable figure, even among banks.
“This is an example of a credit union that is large enough, [say] $6 billion in assets, that they can be dominant in their state and in a lot of small- and medium-sized markets,” says Glenn Christensen, president of CEO Advisory Group, which advises credit unions.
Unsurprisingly, growth and earnings often go hand in hand. Many of the nation’s fastest growing credit unions are also high earners. Size and strength matter in the world of credit unions, as larger credit unions are able to afford the technology that attract and keep members, just like banks need technology to keep customers. These institutions also are able to offer competitive rates and convenience over smaller or less-efficient institutions.
“Economies of scale are real in our industry, and required for credit unions to continue to compete,” says Christensen.
The largest credit unions, indeed, have been taking an ever-larger share of the industry. Deposits at the top 20 credit unions increased 9.5% over the last five years; institutions with below $1 billion in assets grew deposits at 2.4% on average,” says Peter Duffy, managing director at Piper Sandler & Co. who focuses on credit unions.
As of the end of 2019, only 6% of credit unions had more than $1 billion in assets, or 332 out of about 5,200. That 6% represented 70% of the industry’s total deposit shares, Duffy says. Members gravitate to these institutions because they offer what members want: digital banking, convenience and better rates on deposits and loans.
“The only ones that can consistently deliver the best rates, as well as the best technology suites, are the ones with scale,” Duffy says.
Duffy doesn’t think there’s a fixed optimal size for all credit unions. It depends on the market: A credit union in Los Angeles might need $5 billion in assets to compete effectively, while one in Nashville, Tennessee, might need $2 billion.
There are a lot of obstacles to building size and scale in the credit union industry, however. Large mergers in the space are relatively rare compared to banks — and they became even rarer during the coronavirus pandemic. Part of it is a lack of urgency around growth.
“For credit unions, since they don’t have shareholders, they aren’t looking to provide liquidity for shareholders or to get a good price,” says Christensen.
Prospective merger partners face a host of sensitive, difficult questions: Who will be in charge? Which board members will remain? What happens to the staff? What are the goals of the combined organization? What kind of change-in-control agreements are there for executives who lose their jobs?
These social issues can make deals fall apart. Perhaps the sheer difficulty of navigating credit union mergers is one contributor to the nascent trend of credit unions buying banks. A full $6.2 billion of the $27.7 billion in merged credit union assets in the last five years came from banks, Christensen says.
Institutions such as Lakeland, Florida-based MIDFLORIDA Credit Union are buying banks. In 2019, MIDFLORIDA purchased Ocala, Florida-based Community Bank & Trust of Florida, with $743 million in assets, and the Florida assets of $675 million First American Bank. The Fort Dodge, Iowa-based bank was later acquired by GreenState Credit Union in early 2020.
The $5 billion asset MIDFLORIDA was interested in an acquisition to gain more branches, as well as Community Bank & Trust’s treasury management department, which provides financial services to commercial customers.
MIDFLORIDA President Steve Moseley says it’s probably easier to buy a healthy bank than a healthy credit union. “The old saying is, ‘Everything is for sale [for the right price],’” he says. “Credit unions are not for sale.”
Still, despite the difficulties of completing mergers, the most-significant trend shaping the credit union landscape is that the nation’s numerous small institutions are going away. About 3% of credit unions disappear every year, mostly as a result of a merger, says Christensen. He projects that the current level of 5,271 credit unions with an average asset size of $335.6 million will drop to 3,903 credit unions by 2030 — with an average asset size of $1.1 billion.
CEO Advisory Credit Union Industry Consolidation Forecast
The pandemic’s economic uncertainty dropped deal-making activity down to 65 in the first half of 2020, compared to 72 during the same period in 2019 and 90 in the first half of 2018, according to S&P Global Market Intelligence. Still, Christensen and Duffy expect that figure to pick up as credit unions become more comfortable figuring out potential partners’ credit risks.
In the last five years, the fastest growing credit unions that have more than $500 million in assets have been acquirers. Based on deposits, Vibe Credit Union in Novi, Michigan, ranked the fastest growing acquirer above $500 million in assets between 2015 and 2020, according to the analysis by CEO Advisory Group. The $1 billion institution merged with Oakland County Credit Union in 2019.
Gurnee, Illinois-based Consumers Cooperative Credit Union ranked second. The $2.6 billion Consumers has done four mergers in that time, including the 2019 marriage to Andigo Credit Union in Schaumberg, Illinois. Still, much of its growth has been organic.
Canyon State Credit Union in Phoenix, which subsequently changed its name to Copper State Credit Union, and Community First Credit Union in Santa Rosa, California, were the third and fourth fastest growing acquirers in the last five years. Copper State, which has $520 million in assets, recorded a deposit growth rate of 225%. Community First , with $622 million in assets, notched 206%. The average deposit growth rate for all credit unions above $500 million in assets was 57.9%.
CEO Advisory Group Top 50 Fastest Growing Credit Unions
“A number of organizations look to build membership to build scale, so they can continue to invest,” says Rick Childs, a partner in the public accounting and consulting firm Crowe LLP.
Idaho Central is trying to do that mostly organically, becoming the sixth-fastest growing credit union above $500 million in assets. Instead of losing business during a pandemic, loans are growing — particularly mortgages and refinances — as well as auto loans.
“It’s almost counterintuitive,” says Mark Willden, the chief information officer. “Are we apprehensive? Of course we are.”
He points out that unemployment remained relatively low in Idaho, at 6.1% in September, compared to 7.9% nationally. The credit union also participated in the Small Business Administration’s Paycheck Protection Program, lending out about $200 million, which helped grow loans.
Idaho Central is also investing in technology to improve customer service. It launched a new digital account opening platform in January 2020, which allows for automated approvals and offers a way for new members to fund their accounts right away. The credit union also purchased the platform from Temenos and customized the software using an in-house team of developers, software architects and user experience designers. It purchased Salesforce.com customer relationship management software, which gives employees a full view of each member they are serving, reducing wait times and providing better service.
But like Idaho Central, many of the fastest growing institutions aren’t growing through mergers, but organically. And boy, are they growing.
Latino Community Credit Union in Durham, North Carolina, grew assets 178% over the last five years by catering to Spanish-language and immigrant communities. It funds much of that growth with grants and subordinated debt, says Christensen.
Currently, only designated low-income credit unions such as the $536.5 million asset Latino Community can raise secondary capital, such as subordinated debt. But the National Credit Union Administration finalized a rule that goes into effect January 1, 2022, permiting non-low income credit unions to issue subordinated debt to comply with another set of rules. NCUA’s impending risk-based capital requirement would require credit unions to hold total capital equal to 10% of their risk-weighted assets, according to Richard Garabedian, an attorney at Hunton Andrews Kurth. He expects that the proposed rule likely will go into effect in 2021.
Unlike banks, credit unions can’t issue stock to investors. Many institutions use earnings to fuel their growth, and the two measures are closely linked. Easing the restrictions will give them a way to raise secondary capital.
A separate analysis by Piper Sandler’s Duffy of the top 263 credit unions based on share growth, membership growth and return on average assets found that the average top performer grew members by 54% in the last six years, while all other credit unions had an average growth rate of less than 1%.
Many of the fastest growing credit unions also happen to be among the top 25 highest earners, according to a list compiled by Piper Sandler. Among them: Burton, Michigan-based ELGA Credit Union, MIDFLORIDA Credit Union, Vibe and Idaho Central. All of them had a return on average assets of more than 1.5%. That’s no accident.
Top 25 High Performing Credit Unions
Credit unions above $1 billion in assets have a median return on average assets of 0.94%, compared to 0.49% for those below $1 billion in assets. Of the top 25 credit unions with the highest return on average assets in 2019, only a handful were below $1 billion in assets, according to Duffy.
Duffy frequently talks about the divide between credit unions that have forward momentum on growth and earnings and those who do not. Those who do not are “not going to be able, and have not been able, to keep up.”
These institutions recently paired subordinated debt raises to buy back discounted shares in immediately accretive transactions. Leadership of both banks attribute the pair of opportunities — and the pricing they were able to obtain — to the pandemic, and other community banks could make a similar trade.
“What had happened was a perfect storm of an opportunity to buy back at a pretty good discount because of the Covid-19 impact on financial stocks, and the popularity or the market that had developed for subordinated debt,” says Paul Brunkhorst, CEO of Crazy Woman Creek Bancorp in Buffalo, Wyoming.
The bank constructed a twofer trade that would leverage investors’ demand for yield while capitalizing on the persistent discount in its shares. Brunkhorst reached out to a larger in-state financial institution about a $2 million private placement of its subordinated debt at a 5% rate; he says the direct placement kept pricing low for the $138 million bank. Crazy Woman Creek then repurchased 15% of its outstanding common stock. The transactions were included in the same Aug. 18 release.
“It wasn’t taken lightly. We are affecting shareholder value in a positive manner. We’re also incurring this debt, so we better be darn sure of the capital position, the asset quality and the regional economy,” he says. “We were comfortable going after the subordinated debt with the primary reason of repurchasing those shares.”
Executives at Easton, Maryland-based Shore Bancshares decided to pad robust capital levels with an additional $25 million in subordinated debt as “safety capital” at the end of August.
So far, the safety capital hasn’t been needed. Second loan modification requests declined to about 10%, and the $1.7 billion bank has yet to experience defaults. Management decided to deploy $5.5 million of those newly raised funds toward restarting its halted share repurchase program at the beginning of September.
The repurchase, which required sign off from the Federal Reserve, was immediately accretive to tangible book value. If fully exercised, the buyback would reduce share count by 4.5%.
“When you can buy stock back at 60% or 70% of tangible book, that’s probably the best thing you could ever do for your shareholders,” says CEO Lloyd “Scott” Beatty Jr. “In terms of rewarding them, I can’t think of a better way to do it.”
Both executives say shareholders have been pleased with the buyback announcements. They also found the capital raise to be straightforward and relatively quick, with healthy demand and pricing. Brunkhorst says he’s surprised more banks haven’t cut out the middleman to solicit demand and conduct their own private placements. It was Shore’s first time raising sub debt; its offering carried a rating from Kroll Bond Rating Agency and a price of 5.38%.
“I would say probably if you’re thinking about [raising capital], I’d get out there as soon as possible. There’s a lot of activity in this,” Beatty says. “I’d be inclined to pick your investment banker and get out and enter the market as quickly as you can.”
2015 is set to become the third year in a row that total capital raised among U.S. banks has increased—on track for more than $140 billion issued by year-end. The recent boon in capital raising activity generally is attributed to the simultaneous increase in public bank stock values. The effect of market values on the decision to raise capital should not be discounted; however, capital demand has continued despite the market’s recent volatility and perceived weakness. Why has this trend continued?
The confluence of three factors, in particular, within the banking industry have helped fuel capital demand and have shifted demand for different forms of capital, including an increased demand for subordinated debt. First, the interest rate on Troubled Asset Relief Program funding has increased to 9 percent for most banks that still hold TARP funds. Second, participants in the Small Business Lending Fund have experienced—or will soon experience—an interest rate hike on those funds to 9 percent or more. Third, banks that deferred interest payments on trust preferred securities in the wake of the financial crisis must determine how to repay the deferred interest after five years or risk default. Each of these factors is prompting banks to consider capital alternatives.
The Rise of Subordinated Debt Subordinated debt has become the darling form of capital for community banks (i.e., those banks less than $10 billion in assets). Thus far in 2015, subordinated debt has comprised 30 percent of all capital raised by community banks—up from 24 percent in 2014 and 7 percent in 2013. Why has this form of capital become so popular?
In simple terms, banks facing rate hikes on TARP, SBLF, and/or repayment of trust preferred securities have taken advantage of the low interest rate environment to raise capital on more favorable terms. Furthermore, the interest expense paid on subordinated debt is tax-deductible and it generally qualifies as Tier 2 capital on a holding company consolidated basis. In other words, newly issued sub debt can enable banks to reduce debt service requirements, increase regulatory capital, and preserve current ownership interests that otherwise could be diluted by raising common equity.
And as banks have become more creditworthy and investors have raised funds dedicated to community bank sub debt investments, the interest rate on sub debt has steadily declined: the median coupon for sub debt issuances in 2015 is approximately 5.25 percent, down from 7 percent in 2011.
You’ve Decided to Issue Sub Debt…Now What? The process of issuing sub debt for most banks is straightforward. Investment bankers generally know investors with an appetite for sub debt and can provide banks with preliminary term sheets relatively quickly. For banks with more than $1 billion in assets, it could make sense to obtain a bond rating from a rating agency; the process generally takes four to six weeks and can be a great marketing tool when raising capital. A solid rating helps banks achieve better terms and opens the door to new potential investors, such as insurance companies, plus it gives investors added comfort in their own assessment of the deal.
Investor demand for sub debt will continue to increase as long as interest rates remain low and bank balance sheets remain strong. Banks considering a future capital raise should understand the benefits of sub debt and seriously consider it while the market is ripe.
Subordinated debt and preferred equity securities are making a comeback, with small community banks placing private offerings among high net worth investors and pooled investment vehicles alike with greater frequency and ease than in years past.
After years of worrying about whether community banks would survive the economic downturn, investors appear to be willing to tolerate the higher risks of subordinated debt, which falls behind senior debt but ahead of equity instruments in a bankruptcy. Major players like StoneCastle Financial and EJF Capital have established investment vehicles to acquire subordinated debt and other fixed-rate securities from community banks. These funds generally seek investments from $2 million to $15 million per institution, with rates from 6 percent to 8 percent and maturities of five, seven or 10 years.
For smaller community banks that have largely been frozen out of capital markets since the beginning of the Great Recession, the thaw presents a welcome opportunity because the benefits of such securities are significant for issuers. First, they do not dilute existing shareholders as occurs in any issuance of common stock. Second, for debt securities, interest payments are tax deductible, unlike dividends to holders of common or preferred shares. Finally, the proceeds of such securities, which may qualify as Tier 2 capital at the bank holding company level, are treated as Tier 1 capital when injected into a subsidiary bank if the company qualifies as a “small bank holding company.”
This shift in the market comes as more banks have the opportunity to use holding company debt to finance bank growth thanks to recent amendments to the Federal Reserve’s Small Bank Holding Company Policy Statement, which increase the policy’s consolidated assets threshold from $500 million to $1 billion and extend coverage to savings and loan holding companies.
As bankers consider whether these securities are the right way to boost their balance sheets, there are at least three major legal issues to consider before making an offering:
First, does the instrument qualify for capital treatment under Federal Reserve and Federal Deposit Insurance Corp. rules? For subordinated debt securities, there are a number of boxes that need to be checked to ensure an offering will qualify for Tier 2 capital treatment under Federal Reserve rules, such as subordination requirements, the elimination of common acceleration provisions, minimum maturity periods and the absence of other provisions designed to protect debtholders. Likewise, for preferred securities to qualify for favorable capital treatment, dividends must be noncumulative and redemption rights, if any, must be at the option of the issuer only. Federal Reserve regulations and policy statements generally require that redemption of these securities be conditioned upon receipt of prior Reserve Bank approvals.
Second, does the offering comply with federal and state securities laws? To qualify for an exemption under the securities laws, it is common to limit subdebt and preferred stock offerings to accredited investors only. However, even under those circumstances, it is important to provide full and fair disclosure to prospective investors to ensure that the offering is eligible for an exemption. As such, an offering memorandum should be prepared for the private offering that complies with applicable federal and state securities laws.
Finally, will the subdebt be sold to individuals or to a pooled investment vehicle? The aggregation of community banks’ subdebt into pools that will be sold to institutional buyers bears a striking resemblance to the pools of trust-preferred securities that proved so challenging to deal with during the last financial crisis. If your company’s subdebt will be issued to a pool, it is important to understand the legal mechanisms that will be available and with whom you will be dealing if there is an event that causes a payment to be missed.
Many community banks are seizing the moment, using such offerings to refinance debt, finance growth, redeem the Small Bank Lending Fund or trust-preferred securities, and pursue acquisitions in a way that is not dilutive to holders of common stock.
That said, subdebt or preferred stock may not be the best option available for all banks, particularly those with minimal holding company senior debt. For those that have not exhausted options to obtain bank stock loans, that market also has thawed and offers rates that are often 100 to 200 basis points less than coupons payable on subordinated debt or preferred equity.