BANKTHINK

Time to Deal with Parent Company Debt

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Decades of double leveraging by bank holding companies created the current looming crisis for the community banking industry, though it is not getting the attention it deserves. The vast amount of outstanding BHC debt has rendered many BHCs insolvent and is blocking the return to a normalized community bank M&A market.

Many distressed community banks have no realistic exit strategy. They will either soldier on, but in a "zombie-bank" state, or eventually collapse and fail under balance sheet and regulatory pressures.

Healthy banks have no desire to assume the balance sheet debt of an acquired bank's BHC, especially today where bank valuations are at or below book value and the assumed debt is treated as part of the purchase price. Community banks with battered balance sheets and competitive disadvantages live in a "No-Man's Land," trying to discern a way to capitalize on what limited equity value may be left in their franchise and stave off continuing capital pressure. This balance sheet problem originated long ago from an operating model common during strong economic times.

BHCs formerly borrowed money in the form of senior secured debt from correspondent lenders, 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. BHCs downstreamed the proceeds from their long-term debt instruments and Tarp into their subsidiary banks and used that capital often for re-lending, later creating massive credit quality problems. This debt and the long-term Tarp obligations that 400-plus BHCs owe the U.S. Government continue to hang on BHC balance sheets.

As capital deteriorated beginning in 2007, regulatory enforcement actions mounted, often preventing banks from paying dividends to their BHC parent — typically its primary source of cash and the cash flow needed to service debt and other operations. The borrow-downstream-lend model worked fine in a stable economy, but created BHC liquidity stress when conditions weakened.

Regulators will be slow to remove enforcement actions and allow capital to drain off bank balance sheets back to the parent company. Moreover, under the source of strength doctrine, BHCs will continue to be required to downstream holding company cash reserves to their bank subsidiaries to support the balance sheet of the depository institution — meaning ongoing liquidity stress and a higher risk of defaulting on debt obligations and potential insolvency for BHCs.

To address liquidity stress, many BHCs are deferring interest on outstanding Trups (permitted for up to five years) and have suspended cash distributions on their Tarp, senior or subordinated debt, or all of these instruments. The Federal Reserve has directed BHCs to do so to preserve holding company liquidity for the benefit of bank subsidiaries or because cash is virtually depleted.

As a BHC's liquidity position weakens and its ability to pay long-term obligations is jeopardized, the board has to evaluate the point at which fiduciary obligations shift from protecting stockholder interests to protecting creditors' interests. Slipping toward the zone of insolvency heightens the legal exposure of the board to creditors. Likewise, the Federal Reserve is likely to ratchet up enforcement rhetoric and remedies, creating potentially more legal exposure for directors. Additionally, as the BHC cash position weakens and debt remains unresolved, its ability to recapitalize itself and its subsidiary bank weakens, M&A exit options lessen and fewer strategic alternatives are available until no viable options remain to revitalize the balance sheet or stave off receivership.

As a first priority, management and the board should be alerted to this issue. The board especially needs to understand the BHC's cash position, cash flows and future cash needs, and pay attention to its balance sheet and regulatory status. The board also needs to appreciate the BHC's parent company-only financial condition and what that stress means from a regulatory, creditor litigation and going concern standpoint.

Viable restructuring alternatives to BHC debt do exist and will open the door to conventional M&A options or attract fresh equity. Management, assisted by legal and strategic finance professionals, should review debt restructuring opportunities with the board. They should discuss how cancellation of indebtedness income created by debt reduction can be offset with net operating loss carryforwards, how the restructured debt may be capital accretive and how the BHC's capital and debt structure can be modified for access to the capital markets and long-term success. Few BHCs examine holding company financial issues this way. Instead, they continue to focus solely on bank level issues. Until boards understand that the holding company's withering cash, capital and financial condition may ultimately interfere with any realistic recapitalization or "exit" through a strategic M&A transaction, the BHC will fail to set itself on the right turnaround course.

Christopher J. Zinski is chairman and Stephen J. Antal is president of Schiff Hardin Strategic Advisers, LLC, an advisory firm headquartered in Charlotte, N.C. This post has been adapted from a white paper that provides an eight step guide for addressing the BHC debt load dilemma.

 

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