Holding Company Liquidity Concerns Will Trigger M&A

During the last decade, consumers took advantage of low interest rates and lax credit to leverage their balance sheets and invest in assets overvalued as a result of asset bubble conditions. Less well understood is that many bank holding companies did exactly the same thing.

During the recent lending boom, banks sought capital that they could leverage to fuel growth. In many cases, holding companies borrowed money that they invested in their subsidiary banks. The banks leveraged the new capital and invested in loans. The reasoning made sense at the time: The relatively low interest cost of a holding company loan could easily be paid with dividends from the subsidiary bank’s earnings.

Much of this borrowing was in the form of trust-preferred securities, which had the added attraction of counting as regulatory capital at the holding company level. In addition, holding companies borrowed from other banks, typically pledging the stock of their subsidiary banks as collateral.

When the recession hit and asset values declined, banks took loan losses and, as a result, did not have earnings to dividend to their holding companies to service the new debt. Moreover, in the more troubled situations, the regulators stepped in and imposed orders preventing banks from paying dividends to their holding companies and preventing holding companies from servicing their debt. This combination of circumstances has caused bank holding companies with outstanding trust-preferred securities to defer payments of interest. Some bank holding companies that had traditional bank debt became unable to make scheduled payments of principal and interest.

Banks with the riskiest profiles experienced asset quality problems early in the recession, and a number of holding companies had their banks seized by the Federal Deposit Insurance Corp. However, as economic conditions have begun to stabilize, banks have been able to stem their losses, and, in some cases, return to some level of profitability, thereby forestalling any immediate need for the FDIC to consider acting to seize the bank.

Banks in this situation are not in imminent danger of failure, but also are not in strong financial shape. As such, they have limited growth opportunities and are unlikely to attract significant investor interest.

We’ve come to a point in the economic cycle where, during the next year, we will begin to see bank holding companies that have survived long enough reach the end of the permitted 20-quarter deferral period on their outstanding trust-preferred securities. These holding companies may have moderately healthy bank subsidiaries, but nevertheless face a liquidity crunch leaving them with no means of being able to pay deferred interest when the deferral period ends. Holding companies that have bank debt with looming maturity dates are exposed to the risk of forfeiture of the stock of their bank subsidiaries collateralizing the debt.

Bank holding companies in this situation have limited options, and the options they do have are unappealing. Holding companies with trust-preferred securities face particularly complicated issues, in that the holders of these securities often are asset pools, many of which are unmanaged and therefore unable to negotiate a settlement until the holding company is in default. The possible phaseout of the treatment of trust-preferred securities as Tier I capital under Basel III may deter prospective acquirers.

Possible solutions include finding a merger partner to acquire the holding company or, if the value of the bank does not exceed the holding company’s debt, to acquire the bank from the holding company, with the proceeds from the sale used by the holding company to repay its creditors to the extent possible.