Community banks have seen improvements in earnings and credit portfolios, as well as decreased bank failure rates--but dark storm clouds remain on the horizon. The rough weather comes in the form of significant debt loads carried by many bank holding companies as a result of decades of double leveraging. This debt load problem has attracted little attention, but is a major impediment to community bank recapitalizations and conventional merger and acquisition activity.
When a community bank's conventional M&A activity is blocked by holding company debt, there's little or no exit strategy. Healthy banks looking to buy other banks have minimal desire to assume all the balance sheet debt of a target bank's holding company. This is especially true in the current market where bank valuations are at or below book value and the debt to be assumed is treated as part of the purchase price. There simply is too great a difference between the value of the target franchise and the debt to be assumed.
This balance sheet problem had its origin long ago. It grew out of an operating model (discussed below) that became commonplace during strong economic times.
Exacerbating the problem: Stress provoked by ongoing credit quality costs and higher regulatory capital requirements.
Community bank boards and management facing this situation must comprehensively address holding company debt.
The first step: Acknowledge it. Boards need to spend time now focusing on holding company debt restructuring alternatives. They must weigh how those options affect the holding company's prospects for attracting fresh equity or a merger partner that will put their bank in a position to survive and prosper as the economy recovers. Along the way, stakeholder value can be enhanced.
Business problem: decades of double leveraging
Bank holding companies borrowed money in the form of senior secured debt from other financial institutions when correspondent lending was customary. They issued subordinated debentures in private placements and participated in the $150 billion trust preferred securities market where TruPS were routinely marketed and issued through collateralized debt obligations (CDOs). Holding companies downstreamed the proceeds from their long-term debt instruments and TARP into subsidiary banks and the banks used that capital to lend--often for construction and land development or commercial real estate projects. Many suffered major credit quality problems along the way. This long-term debt, in addition to the long-term TARP obligation some holding companies owe, continues to cloud holding company balance sheets.
As a general matter, smaller holding companies--those with less than $1 billion in assets--have less leverage than larger ones. However, an increasing number have ratios of debt-to-bank-level equity in excess of 100%. This implies that much of the bank-level capital is comprised of holding company double leverage. In 2011, more than 170 holding companies with assets of $1 billion or less had long-term debt-to-equity ratios over 100%, more than twice the number in 2008. This is not because these smaller holding companies had been adding debt during the financial crisis; rather, their equity has been declining over this period, exacerbating the debt-to-equity imbalance.
By contrast, in 2011, holding companies with greater than $25 billion in assets had a parent company-only long-term debt-to-bank-equity ratio of 28% while holding companies with assets of $1-$5 billion and $5-$25 billion had ratios of 14% and 13%, respectively. The holding companies in the $5-$25 billion asset size range can manage their debt load more effectively than smaller banks, having ready access to the capital markets and liquidity sources.
As capital deteriorated because of credit losses since 2007, regulatory enforcement actions mounted and those orders prevented banks from paying dividends to their holding company parent--typically the primary source of cash and earnings for the parent company and the cash flow needed to service holding company debt and other operations. The borrow-downstream-lend model worked fine in a stable or growing economy but created holding company liquidity stress when the economy and credit conditions weakened during the financial crisis.
Regulators will be slow to remove enforcement actions and allow capital to drain off bank balance sheets back to the parent company, even as balance sheets stabilize in a recovering economy. Moreover, under the source of strength doctrine, holding companies have been and will be required to downstream holding company cash reserves to their bank subsidiaries to support the balance sheet of the depository institution. All of this means that holding companies will continue to experience ongoing liquidity stress and a higher risk of defaulting on holding company debt obligations and insolvency.
BHC liquidity stress
The deterioration of bank credit portfolios during the financial crisis, combined with regulatory enforcement actions that prohibit bank dividends to the holding company and general regulatory prohibitions on the up-streaming of dividends if the subsidiary bank is unprofitable, have caused holding company liquidity to deteriorate. In some cases it has drained to zero.
Holding companies with less than $1 billion in assets in 2011 had ratios of parent-company only cash and securities to long term debt of 8%, in contrast to holding companies with assets of $1-$5 billion and $5-$25 billion that had ratios of 17% and 28%, respectively. Holding companies with assets of $25 billion and greater had a ratio of 49%. The smaller holding companies are under more severe liquidity stress than their larger counterparts and their options for securing more liquidity are generally limited. Indeed, for smaller holding companies, holding company liquidity can only be increased by raising equity at the holding company level, a very expensive funding source and also a difficult, if not impossible, one to tap in the current environment.
Holding companies have had choices to make over the last six years in managing their holding company cash flows. Cash flow uses have included debt service on senior secured facilities originated when correspondent lending was conventional and available. Cash flow has also been needed for debt service on TruPS; debt service on subordinated debentures; and cash distribution requirements of TARP instruments. These cash obligations have strained holding companies' balance sheets, causing many holding companies to elect to defer interest on TruPS for five years, discontinue TARP payments, or default on senior secured notes or subordinated debentures--or all of the above. Moreover, the Federal Reserve, through enforcement actions, has directed holding companies to conserve cash and stop paying on these instruments, reflecting regulatory intervention to manage holding company liquidity problems.
Ironically, regulatory efforts to put teeth into the "source of strength" doctrine have in some cases further strained holding company liquidity to the breaking point as funds have been downstreamed to support bank subsidiaries.
Given the duration of the financial crisis and the sluggish nature of the recovery, many holding company balance sheets are under pressure. Cash on holding company balance sheets is running out, and while the TruPS interest deferment buys time, the day of reckoning is right around the corner as accrued but unpaid liabilities have grown dramatically. As an industry, many holding companies are two-and-a-half to three years into five-year permissible interest deferments, which, when the deferment period ends, will require the holding company to pay off the interest accumulated over the deferment period--a seemingly impossible objective given holding company cash positions.
Furthermore, the market solutions are not plentiful. Few, if any, correspondent lending and other liquidity support alternatives are available. And while a holding company capital injection would improve liquidity, capital markets may not be receptive to fresh equity, particularly for distressed holding companies.
There is an argument that bank balance sheets have improved as well as their earnings prospects. If that improvement continues and assuming a growing economy, bank-level balance sheet improvements should improve the balance sheets of the parent company. But will it come fast enough so that adequate amounts of cash can be up-streamed to the holding company to address the end of the TruPS interest deferment and meet or bring current other holding company obligations?
Moreover, many holding companies need significant capital injections in the near term to restore capital levels at the bank level to improve regulatory standing and ensure safe harbor from receivership. The holding company debt burden will continue to present capital-raising and strategic M&A challenges.
Recognizing the risks
As a holding company's liquidity weakens and its ability to pay its long-term obligations is jeopardized, the board of directors must evaluate the point at which fiduciary obligations shift from protecting stockholder interests to protecting, as a first priority, the interests of creditors. Slipping toward the zone of insolvency heightens the legal exposure of the board to creditors. Likewise, the Federal Reserve is likely to ratchet up its enforcement rhetoric and remedies, potentially creating more legal exposure for directors.
This is in addition to the basic business problem, which is that as the holding company cash position weakens and its debt remains unresolved, the holding company's ability to raise capital to recapitalize itself and its subsidiary bank likewise weakens. M&A exit options lessen, and fewer and fewer strategic alternatives are available until no viable options remain to revitalize the balance sheet or stave off receivership.
What is the reasonable business response?
The first step is getting the attention of management and the board of directors.
The board needs to be aware of and understand the holding company's cash position, cash flows, and future cash needs. Too many boards focus exclusively on the bank's balance sheet and regulatory status and ignore or give only slight attention to the predicament of the holding company. The board needs to understand the holding company's parent company-only financial condition and what that stress means from the perspectives of regulatory interests, creditor litigation possibilities, and a "going concern" standpoint. Management should be regularly updating the board on the holding company's financial status and potential available liquidity options.
Holding company debt can be restructured, thus, opening the door to conventional M&A options or as an inducement to bringing fresh equity into the company. As the trading market for TruPS has become more active, we have found a growing receptivity amongst new holders to conversions, recapitalizations, and Chapter 11 transactions, including 363 Sales and pre-packaged bankruptcies.
Management, with the help of legal and strategic finance professionals, can and should review with the holding company board debt restructuring opportunities and how:
â€˘ Cancellation-of-indebtedness income (created by debt reduction) can be offset with net operating loss carryforwards.
â€˘ How the restructured debt may be capital accretive.
â€˘ How the holding company's capital and debt structure can be modified for access to the capital markets and long term success.
A sense of urgency is critical here. In our experience, very few holding companies are examining holding company financial issues in this way. Instead, their focus remains primarily on bank-level issues.
We submit that until a holding company board understands that the holding company's withering cash, capital and financial condition may ultimately interfere with any realistic recapitalization, bankruptcy alternatives, or "exit" through a strategic M&A transaction, the company will fail to set itself on the right turnaround course.
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