The National Credit Union Administration's proposed risk-based capital rule could limit the size and number of credit union acquisitions of banks this year, say several sources close to these deals.
Merger experts, including those who know of pending and potential CU/bank agreements, say the new capital rule as written could shrink much-needed capital cushions; create a great deal of uncertainty among acquiring CUs while thinning their ranks; and make it imperative that the bank being acquired is a perfect fit.
All agree, though, the rule won't stop the mergers, whose numbers have been rising.
Peter Duffy, managing director at Sandler O'Neill in New York, who works with both CUs and banks on mergers, sees credit unions' capital cushion and confidence shrinking due to the new rule.
"How can the credit union be certain the merger makes sense since the merger dilutes their capital position and the credit union may have increased capital requirements?" asked Duffy.
A smaller capital cushion and CUs' inability to raise capital outside of retained earnings require there be no "surprises" in the bank deal, according to Duffy. "[There must be very] clean assets and the credit union has to identify exactly where all the cost savings are. There is no wiggle room for mistakes or bad assumptions in pre-merger due diligence," he said.
Considering the potential effects of the proposed rule, and the average asset size of credit unions, Duffy said the "math does not imply there will be a ton of deals where credit unions acquire banks above $500 million in assets."
In a previous Credit Union Journal report, analysts noted that more banks and bigger ones — above $500 million in assets — would be willing to sell in 2014, due largely to bank executives becoming weary over growing compliance costs and having a hard time generating sufficient profits in a low interest rate environment (Credit Union Journal, Nov. 27).
Rule Could Slow Down Deals
Michael Bell, attorney and counselor with Royal-Oak, Mich.-based Howard & Howard, agreed the proposed new capital rule could slow CU purchases of banks above $500 million in assets, but won't completely stop them. "Some of the bigger credit union players are now taking a harder look at banks," Bell said.
Five deals involving credit unions and banks have been signed in the last two years: The $260 million-asset Five Star CU, Dothan, Ala., is acquiring the $23 million Flint River National Bank in Camilla, Ga.; in Baltimore, the $1.2 billion Municipal Employees CU is purchasing $61 million Baltimore-based Advance Bank; Wisconsin's $2.1 billion Landmark CU acquired $190 million Hartford Savings Bank; Massachusetts' $429 million GFA FCU acquired New Hampshire's $83 million Monadnock Savings Bank; and the credit union that put everything in motionMichigan's $1.6 billion United FCU — acquired $81 million Griffith Savings Bank in Indiana.
Bell, who has worked on four of those deals, expects there could be five announcements of CUs buying banks this year despite the new rule's potential impact. He believes the best model for most credit unions is targeting banks below $500 million, since most banks are not courting these institutions he said.
"I think this is virtually an untouched merger market," said Bell. "There is little to no M&A activity among banks at this asset level. Credit unions can be that opportunity."
Attorney Richard Garabedian predicts that tighter capital requirements will cause CU/bank deals to be mostly on the "smaller side" because credit unions will rely on cash to make the purchase.
"For a $500 million bank you would need a credit union of $1 million in assets to perhaps $1.5 million to make the transaction," said the partner with the Washington firm Luse Gorman Pomerenk & Schick, who represented Monadnock Savings Bank in the GFA deal. "If it's a stock bank, the credit union will have to have a hefty capital ratio to pay out the cash to shareholders."
Garabedian said he is currently in talks with two banks and credit unions considering deals. "They are kicking the tires," he said. "The credit unions are about $500 million and the banks are under $200 million." (Garabedian declined to name any of the financial institutions.)
Some analysts say a credit union has to be about twice the size of the bank it is acquiring to absorb it and remain well capitalized. Duffy gave the example of a $1 billion-asset bank with 10% capital purchasing a $100 million bank with 10% equity. He said it would cost the CU $14 million in cash at 1.4% of book value.
"Subtract the $14 million from the $100 million in equity the credit union had before the merger and you get $86 million in equity," explained Duffy. "Add back the $10 million from the bank's equity and you get $96 million in capital. With the addition of $100 million in assets, the CU is now a $1.1 billion shop."
Divide $1.1 billion by $96 million and the CU's net worth is now 8.7%, and it may not want to drop down that low, offered Duffy. "That math tells you, with about 200 credit unions above a billion in assets, and with higher capital standards, there will not be a bunch of deals for banks above $500 million this year."
But Bell disagrees that the CU has to be twice the size of the bank to make the acquisition work. "I don't think we should get too granular in analyzing the size of the credit union, not if the credit union has capital to burn. There are a lot of credit unions sitting on hefty capital positions."
Sizing Up The Fit
Numbers aside, credit union execs and analysts emphasize the fit between the bank and credit union can be the critical factor, stressing the importance of the two organizations meshing culturally and operationally. That was the case when GFA FCU completed the purchase of Monadnock Savings Bank in late 2012.
"It was the perfect deal and it came at the right time — we had a lot of capital," said David Bojarczuk, SVP, director of corporate finance and CFO at GFA.
United FCU, the first CU to buy a bank when it completed the deal for Griffith Savings Bank in early 2012, said the CU has looked at other opportunities since Griffith, but has not found the right fit.
"There is no universal 'fit metric,'" said United CEO Gary Easterling. "Each opportunity must be evaluated based upon how it enables and informs your strategy, affects your current capacity and possibly delays other opportunities. It is a very fluid calculation, and it is unique to every institution and every transaction."
Today, with the proposed new capital rule, the fit needs to be even tighter, sources say. While the assets of the bank being purchased are always closely scrutinized when the CU assesses potential deals, the new rule's risk weighting requires assessing whether any of the bank's assets will negatively impact the CU's risk-based capital ratio.
Bojarczuk gave the example of the merger taking on loans that increase real estate paper to above 35% of the loan portfolio, taking risk weighting to 100% for a percentage of the CU's mortgages.
"That will affect your capital position," Bojarczuk noted. "If the acquisition has a large, negative impact on the risk-based ratio, NCUA could stop the deal. That's why, anymore, the merger has to be a perfect fit."
Duffy predicts that since assets have to mesh so well now, credit union and bank combinations are less likely than before the proposed capital rule. "The acquirer will need to move, in most cases, lower in target asset size while increasing the need to model the balance sheet mix impact on risk weighting of the combined institution," he said.
Experts and CU execs also noted that the new rule subtracts goodwill from net worth when calculating risk-based capital requirements, something that may prompt CUs not to take on a troubled bank, or pay a premium over book value.
Bell acknowledged that the new capital rule has already affected the decision of one credit union, with it putting a pause on a potential deal. "That is an unintended consequence of the proposed rule, and it is unfortunate," he said. "But by the time this rule is final, adjustments are made to it and uncertainty around the proposal is gone, I think the new rule will have less of an impact on credit union purchases of banks."
Easterling simply said that rules that constrain capital impact any growth initiative.
"Mergers and acquisitions are no different," the CEO said. "We are still evaluating the impact of the rule. My intuition is the more complex your asset mix, the more the new rule impacts you."
Increased due diligence underscores the need to have skilled partners when evaluating a target, sources noted. "If you are considering acquiring a bank or a portion of a bank, be certain you have solid counsel in your evaluation of the asset — current value, future value, and the total cost of acquisition, conversion, and integration into your culture and your operations," said Easterling.
Bojarczuk worked with Howard & Howard's Bell and an investment banker, since Monadnock was a stock-owned bank. "We had excellent partners," he said
How Big Is The Bank Pool?
But just how big is the pool of banks below $500 million for CUs?
Duffy and Garabedian are not certain, both saying a healthy bank will first choose to sell to another bank. Both see the cultural fit as one reason, but the attractiveness of getting both stock and cash the deciding factor.
"CUs can offer just cash," said Duffy. "Most healthy banks will find the combination of cash and stock to be much more attractive. If the bank is struggling, as has been the case in most of the previous CU purchases of banks, that is where you will see some credit union acquisitions of banks, if any."
Bell disagreed. "Looking back on the credit union buys, some banks were troubled and some were not," said the attorney. "I think credit unions have an advantage when bidding on a healthy bank because they will pay a premium over book value if the bank throws off cash immediately. In the case of bank boards and management not wanting to be in it for the long haul, and don't want to take a bet on stock, cash has its advantages."
Sources also stated that credit unions are looking with greater interest at bank purchases because many smaller CUs, except tiny ones, are not willing to merge due to boards and CEOs being unwilling to give up their roles despite the merger being the right decision for members.
Ask GFA and United about results from a credit union acquiring a bank and they will say the deals are good. Both credit unions are pleased with the performance of their acquisitions and will do another if the right opportunity arises.
Bojarczuk said the Monadnock purchase performed from the start and has improved the CU's overall earnings. Easterling noted that the Griffith Savings pickup was slow to take off, but has become a solid move.
"We needed to work through underperforming assets, convert to our systems, and embrace the team into the United culture," Easterling said. "With that in place, we have been able to grow local confidence that we are invested in the Griffith community. I like where the acquisition is, and where it is heading."
