Fed holds community banks hostage in TruPS CDOs
Small US banks, along with insurers that issued trust preferred securities that were subsequently bundled into murky collateralised debt obligations before the crisis, are stuck between a rock and a hard place. Having deferred coupon payments for as long as they can, they’re under pressure from CDO holders to cough up — but even though they want to, the Fed won’t let them.
Regional and community banks that are just beginning to recover from a real estate crisis now face being forced into involuntary bankruptcy.
Buoyed by a successful case against Minnesota’s American Bancorp and a court ruling against Georgia’s FMB Bancshares, Trust preferred securities (TruPS) holders are working together to collect their dues. It’s Wall Street versus Main Street — and the Washington Federal Reserve is leaving Main Street in helpless limbo.
Many banks that issued TruPS before the crisis have since gone bust or been acquired by larger entities. Of those that survived, most have written agreements with banking regulators that prohibit them from making distributions on TruPS, even though they’re returning to health.
Fitch Ratings estimates that 51 bank issuers in 41 TruPS CDOs — totalling approximately $400m — will reach their five year coupon deferral limit by the end of 2014. Some 41 of those banks are prohibited from paying those coupons. But experts reckon that as many as 450 banks will face this issue in the coming months.
Trapeza Capital Management, a collateral manager of several TruPS CDOs, filed a Chapter 7 involuntary bankruptcy petition against FMB Bancshares after its deferral period ended in June.
Naturally, FMB appealed, claiming that its agreement with the Fed did not allow it to pay the coupons. But the courts upheld the bankruptcy ruling, saying that “the fact that FMB cannot make any payment on its debt to Trapeza does not waive its legal duty to pay”.
That is an encouraging sign for TruPS holders, many of which are hedge funds that bought up the instruments for pennies on the dollar during the financial crisis. The court’s decision shows it clearly views TruPS as a debt instrument with creditor rights, whereas the Fed argues that it is equity and therefore subject to distribution restrictions.
No way out
Speaking on condition of anonymity, the president of a $160m community bank in Kansas told GlobalCapital that repeated attempts to find a way round the Fed’s restrictions had been shot down.
“We are in the middle of a capital raise that has already started,” he said. “We already have cash from the capital raise at the holding company level. But we have been told informally that the Fed will not allow us to make payments on the TruPS with brand new capital.”
“It seems unusual that a bank that is raising capital cannot use it for the benefit of the organisation. I don’t know why they would do that.”
The bank has even tried a workaround using an escrow agent, which involves the bank’s shareholders basically paying the coupons themselves in return for new equity.
“The shareholders would raise the capital, put it into escrow, and the escrow agent would pay the TruPS holders the deferred interest. In exchange for that, the bank holding company would issue stock.”
“The holding company isn’t even proposing to take possession of the money — it would be directly from our shareholders. But the consensus was that you can’t do that.”
Local regulators are reportedly trying to help their constituent banks. GlobalCapital understands that the St Louis Fed allowed one of its banks to use the escrow agent solution — but the Washington Fed gave it a slap on the wrist. None of the parties in question could be reached for comment before publication.
Frying pan, meet fire
For banks that struggled through the financial crisis, such pressure is all too familiar.
“About 20 other banks in this town failed or were forced to merge during the crisis,” said the community bank president. “We survived it, but now we’re in this situation. The TruPS holders may just say they’ve got no alternative. If the Fed won’t let the banks work with them, the TruPS holders will just take the banks through to bankruptcy court.”
The only hope for now is to negotiate with the CDO holders, he said: “If you have a borrower that is attempting to give you a solution, you generally try to cooperate.”
But while holders of the CDOs may know which banks they are exposed to, the banks themselves may not know which CDOs their TruPS were bundled into, said Mike Manning, CEO of DealVector, an online platform that helps connects the various counterparties in structured finance transactions.
“If you are coming up to the end of your deferral period, you need to figure out which CDO holds your bond,” he said. “Once you figure that out, you can talk to them.”
In 2010, Fitch reported that Indy Mac, the second largest thrift failure, appeared in 28 separate TruPS CDOs, more than a quarter of all issued. On average, failed banks and thrifts were included in 4.2 separate CDOs.
But even if banks can get in contact with those investors, that doesn’t mean everyone’s interests are aligned. “These are unattractive, hold-to-maturity securities,” Manning said. “If the TruPS CDO holders can get out at 90 cents on the dollar, they would rather have the cash than have the bond cured and continue to pay out at a low yield.”
The low yields on TruPS make the Fed’s position even more unfathomable, said Greyson Tuck, a lawyer at Memphis, Tennessee firm Gerrish McCreary Smith, which has worked with community banks facing this predicament.
“It drives me nuts, because this is just about the cheapest capital these banks could get,” he said. “The bank needs to make a small interest payment from the bank to the holding company, and it gets another five years of capital. But the banks are looking at their creditors and saying their hands are tied.”
Source of strength
The Fed argues that bank holding companies should be a source of strength for the subsidiary bank, meaning any cash raised by the holding company needs to be put down into the bank and any excess cash at bank level cannot be sent upstream to the holding company that issued the TruPS.
Banks won’t be able to get around the Fed’s restrictions on TruPS distributions until they are stronger. That requires raising more capital.
“But who is going to buy stock in a bank with a $1.2bn liability associated with a $600m note that is about to go into default?” asked Tuck. “The Fed is not giving these institutions any leeway.”
The holders of TruPS CDOs could wait for the Fed to see sense and allow banks to pay their coupons. In many cases, attempting to be made whole by forcing a regional lender into involuntary bankruptcy might result in a pitifully small recovery. But that doesn’t mean the problem is going away.
“It will continue,” Tuck said. “As bank valuations continue to improve, the transaction [TruPS CDO holders forcing involuntary bankruptcy] becomes more and more enticing.”
However, the uncertainty of bankruptcy court and the lack of data also make that enticing transaction a fraught proposition, Manning at DealVector said.
“There are not a lot of data points to guide either side, and there is no clearing price established in the market — so you don’t know what the true economic costs of bankruptcy are for either side. Part of the challenge is dealing with sides that are culturally very far part, with an insufficient data set to determine who is right.”