By Evan Sparks and Margaret SweenyDepositor-owned mutual banks—which have long faced the competitive challenge of building capital solely from retained earnings—have historically run high on capital levels. Building capital through retained earnings is slow work, so mutuals need more of a buffer.
But mutual bankers are increasingly finding reasons to turn to subordinated debt offerings to enhance regulatory capital levels. Sub debt, a fixed-income product which is junior to other debt issued by the bank, can meet regulatory requirements for Tier 2 capital.
Once rarely used by mutuals, “sub debt is something that is being issued at very high levels,” says Richard Schaberg, a partner at Hogan Lovells. “Now we’re starting to see more and more mutual institutions taking advantage of this sub debt structure as a way to augment their capital.”
Mutuals’ high capital levels may not make it obvious, but sub debt can expand options, notes Tom Fraser, president and CEO of Lakewood, Ohio-based First Mutual Holding Company, which has two affiliated thrifts (and counting) with over $1.8 billion in assets. “It’s not out of the question that we might want to buy branches or buy a stock bank someday,” he says. “To do that we worry about what might happen to our capital. Or even if we had two mutuals merge together with acquisition accounting, it could take your tangible capital down lower than you thought.”
“You might be standing there thinking, ‘We are never going to buy a stock bank so what do we need this for?’” says Schaberg. “Well, one thing you never want to do as a banker if you are in the enviable position of growing is to have to turn the spigot off. One of the big advantages here is to have the ability to continue to grow by augmenting your capital from outside sources.”
Another factor in the growth of sub debt is its use as a way to manage commercial real estate or construction loan concentrations, an area of heightened regulatory focus, adds Schaberg. And mutual-to-mutual mergers can benefit from sub debt, says Fraser, a veteran of mutual tie-ups who has created a new no-stock MHC to maintain mutuality as a choice for Ohio community banks. “You wouldn’t think that capital would be a concern, but when you go through the planning process of it … that can create a little bit of surprise in terms of what happens to your tangible capital,” he explains. If loans in one bank’s book have to be marked down, that affects capital levels. “You might want to have a little bit of sub debt to offset that temporary capital gap until the loans begin to creep back into income and that can provide a buffer,” he adds.
Nuts and bolts
Subordinated debt has certain strict features to qualify as Tier 2 capital. It can’t accelerate; it has to be non-callable for five years; it has to be issued by a holding company to get the Tier 2 treatment. “It’s a predefined capital instrument if you will, driven by the capital rules,” says Schaberg. “But if you take the proceeds and push them down to your bank, as cash, you get Tier 1 capital treatment—a really helpful feature there. Probably one of the best uses of a no-stop mutual holding company is to have the availability of getting Tier 1 capital treatment downstream to yourself.”
This is particularly valuable “if you’re an institution that looks at those assets as exempt from bank holding company capital requirements,” says Dan Flaherty, an investment banking principal at FIG Partners. “That can be very advantageous. We’re seeing that asset class really hit this market right now.”
Unlike equity investors, sub debt buyers have no voting rights or ability to influence management. A sub debt owner is “strictly a removed investor who’s looking for a quarterly payment of a coupon,” says Schaberg. “When looking as mutuals to preserve your long-term planning—your vision going forward—it’s important to note that by issuing sub debt you’re not triggering something unintended by having someone who has placed an investment with be able to influence your strategic direction.”
The three main categories of sub debt investors are professional asset-liability managers, such as insurers; equity investors in community bank stocks that want to add a fixed-income piece to an equity portfolio; and banks investing in other banks. “Think about your loan portfolio and its yields,” observes Flaherty. “These offerings are going up anywhere from the mid-fives to as high as 8 percent. When you think about that compared to your loan portfolio, a lot of banks are investing in other banks’ sub debt, underwriting it as a loan, and kicking up the yield in their portfolio, which is very advantageous to your earnings.”
The purchase agreement is fairly standard, Flaherty adds. Most investors take portions of $1 million or more, so a $10-15 million offering may see about 10 investors. The “pretty seamless process” is generally handled by the investment banking firm and legal team, he says. “There are not a lot of due diligence concerns. With banks, generally a lot of information is disclosed publicly, so it’s not very burdensome on your company to issue it.”
Schaberg notes that the due diligence is “much more truncated that it would be otherwise if it were a common stock or a merger.” The key question for the investor: can the bank meet its quarterly debt service? As a result, the transaction is relatively simple, he says, and is traditionally handled as a private placement.
Placing sub debt may be fairly straightforward, but the planning required by the issuing bank is significant. “You have debt service going forward potentially for 10 years or longer,” comments Schaberg. “You obviously need a robust financial model that shows that you have the wherewithal to pay that.” It also requires attention to the end game—what happens when the debt comes due or needs to be refinanced. “The sub debt market for banks has not always been open,” says Flaherty. “It was closed for a long time for banks and it really reopened in 2014. So to say ‘I’m going to issue it today and I know that I’m going to just reissue it in 2027’—there is a risk to that.”
Mutuals planning for growth should evaluate their capital options early, Flaherty adds. “Like any kind of borrower, when you are talking about capital levels, you get your best terms and your best rate when you don’t need it.”
Fraser’s board asks these questions: “Does it fit our business plan? Is it a responsible tool and one we can pay back and perform on? Is it the best alternative to execute our business plan? Does it in any way compromise our independence, harm our depositors or compromise our future as a mutual institution?”
When First Federal Lakewood formed a mutual holding company two years ago, Fraser said he wanted to avoid signaling to depositors that the bank would be on a “slippery slope” toward stock ownership. Many “worry about what kind of signals it sends if you try to raise sub debt and want to adopt a holding company form,” he says.
“The issue of sub debt is in no way inconsistent with retaining your mutuality,” adds Flaherty. “In fact, it’s a way to continue to enhance it and embrace it.”