Capital raising efforts among financial institutions began in earnest in late 2007, primarily among money center banks and investment banks suffering under the weight of mark-to-market adjustments on various asset types. Banks with fewer assets marked to fair value through the income statement largely maintained sufficient capital to manage the initial wave of industry problems. However, the capital pressures intensified in 2008 as past-due levels and losses increased across a spectrum of loans tied to real estate, causing a number of banks to reassess their capital positions and, in some cases, to capitulate under the weight of the external environment and seek out additional capital.
This article provides a summary of capital raising transactions that have occurred in 2008 and offers insight into the financial considerations present in evaluating each capital alternative. These considerations are relevant whether a bank is in the position of raising capital to buttress the balance sheet or, alternatively, has an opportunity to make an investment in another bank facing a capital shortfall.
The surest way to shore-up capital ratios is through the issuance of common stock, which places no pressure on the company’s cash flow if no dividends are declared. The primary disadvantage of common stock offerings is the dilution that current shareholders may experience to their ownership positions and future earnings per share.
Figure One indicates recent common stock offerings. Most of the issuances have occurred at discounts to the issuer’s stock price prior to the transaction. In one-half of the issuances, the offering price for the common stock was less than pro forma tangible book value per share (existing tangible book value, plus the equity raised in the offering). One recent article noted that investors were potentially willing to purchase stock at tangible book value per share, as adjusted to reflect the investors’ estimate of expected losses in the loan portfolio.
In considering a common stock issuance, important questions for community banks to consider include:
Depending on its structure, preferred stock can bear a resemblance to either long-term debt or equity. In its simplest form, “straight” preferred stock economically resembles long-term debt with either fixed or floating rate payments. Convertible preferred stock is a hybrid instrument that combines elements of both debt and equity. Generally, convertible preferred stock has a lower dividend rate than straight preferred stock, but a higher yield than common stock. To compensate investors for accepting the lower current return, the investors receive the right to participate in the appreciation of the common stock. Further, preferred stock dividends can be either cumulative (meaning that dividends are accrued in the intent of paying such dividends later) or noncumulative.
From a bank’s perspective the advantages of preferred stock include:
Potential disadvantages from a bank’s perspective include:
From an investor’s perspective, preferred stock can be an attractive alternative to common stock. For convertible preferred stock, the investor may receive a dividend in excess of the common stock’s dividend, plus the right to enjoy appreciation in the underlying common stock. Thus, the higher dividend protects the investor’s downside (to the extent the issuer actually pays the dividend). Further, if the investor is a corporation, the tax deduction for dividends received may be available.
Preferred stocks have been a popular capital raising tool in the present environment, owing to their flexibility and the downside protection afforded to investors. Figure Two indicates issuances announced during 2008.
When structuring a preferred stock issuance, important considerations include:
From an issuer’s perspective, the most unattractive terms include a high dividend rate and a low conversion premium. As an example, consider South Financial Group’s May offering of 10% preferred stock with a 0.3% conversion premium.
Trust preferred securities are a hybrid instrument, combining the tax treatment of debt and the Tier 1 capital treatment of equity. From a bank’s perspective, the favorable after-tax cost of capital represents one of the primary advantages. Prior to late 2007, another significant advantage of trust preferred securities was that community banks could easily access the capital markets by participating in one of the pooled offerings underwritten by investment banks. As conditions in the credit markets deteriorated, this advantage disappeared, as the pooled offerings have largely vanished from the marketplace, although they may eventually return if investor demand improves.
Figure Three indicates data on trust preferred securities offerings announced in 2008 by publicly traded banks. While pooled offerings have not occurred in 2008, several smaller publicly traded banks have placed trust preferred securities with institutional investors. The pricing in these offerings has increased since the last pooled offerings, which often contained spreads in the range of 150 basis points over LIBOR. The variable rate offerings indicated in the table contain spreads in the range of 350 basis points over LIBOR.
While the availability of trust preferred securities through pooled offerings is currently uncertain, other investors may exist. Alternatively, banks can consider issuing trust preferred securities to local investors or shareholders. Although this type of offering may require more time and professional fees than a pooled offering, the bank will still enjoy the significant tax and capital benefits of trust preferred securities. Questions to consider for banks include:
In the event that the bank needs to raise Tier 2 capital, instead of Tier 1 capital, subordinated debentures may be desirable. Subordinated debentures may be included in Tier 2 capital, subject to a limitation equal to 50% of Tier 1 capital. Like trust preferred securities, interest payments on subordinated debentures are tax deductible. Subordinated debentures can be issued at the subsidiary bank level, which may decrease their credit risk for investors, relative to instruments that require the holding company to maintain sufficient liquidity from bank dividends or other sources of funds.
Figure Four indicates the pricing of subordinated debenture offerings in 2008. While few community banks are included in this group of offerings, subordinated debentures may remain an attractive alternative to curing a Tier 2 capital need. Transactions announced in April and May have occurred at interest rates ranging from 8.75% to 9.50%. All of the issuances have involved either ten or thirty year terms.
For community banks where subordinated debentures may solve a problem, the following questions should be considered:
For community banks needing capital, the alternatives possess substantially different impacts on existing shareholders and the bank’s future returns, not to mention divergent capital treatments. For potential investors in community banks, downside protection is important in the present environment. As a result, recent capital raises have included common stock issued at discounts to the issuer’s market price and convertible preferred stock issuances with relatively high dividend rates and low conversion premiums.
Mercer Capital can assist community banks and investors with considering the advantages and disadvantages of the spectrum of capital instruments available to a particular bank, focusing on their effects on existing shareholders and future shareholder returns, as well as evaluating the pro forma capital impact of different instruments and offering amounts. We can also assist banks and investors in determining an appropriate stock price or interest rate in offerings sold to local investors, analyzing, from an investor’s standpoint, the advantages and disadvantages of different proposed investment structures, and providing fairness opinions that the capital offering is fair to a specified group of shareholders.
Reprinted from Mercer Capital’s Bank Watch 2008-05, published May 28, 2008.