Hundreds of community banks in trust-preferred limbo now have an example of the worst-case scenario if they fail to reach an agreement with debtholders.
American Bancorp. in St. Paul, Minn., last week became the first lender to be forced into bankruptcy over trust-preferred securities. American entered liquidation when a group of companies that manage collateralized-debt obligations backed by the bank's trust-preferred securities pressed for involuntary bankruptcy to collect on $48.1 million in debt and unpaid interest.
The companies that forced the liquidation Fortress Investment Group, whose affiliate manages the CDOs, and Cohen & Company Financial Management, an investment bank are big players in the trust-preferred market.
The bankruptcy could be a wake-up call for other banks in danger of defaulting on trust-preferred securities. It will also serve as a test of the most aggressive option for prying payments from recalcitrant banks, and it will give regulators a hint of how a forced bankruptcy will impact American's bank.
"What you're seeing with this case is the development of strategies," says Brennan Ryan, a partner at Nelson Mullins. "Other banks that are at the end of the Trups deferral period are going to ask, 'Can't we just wait it out and see what happens?' The answer is no, and this case will serve as an example of why not."
Trust-preferred securities, a debt/equity instrument that was a popular capital source a few years ago, let banks defer paying interest for five years, after which point creditors can demand full repayment. Most in the industry estimate that 250 to 300 community banks will hit the end of their five-year deferral periods by the end of 2015.
Banks and investors are starting to signal their strategies for the coming surge of trust-preferred defaults. For several years, bondholders were reluctant to allow holding companies to file bankruptcy and sell their banks, fearing that the sale price would not give them the best possible return. But the bids have been strong in several recent bankruptcy auctions, making bondholders more willing to consider this strategy.
Some companies laden with trust-preferred securities, like First Mariner Bancorp and North Texas Bancshares, voluntarily filed for bankruptcy protection and sold off their banks after hitting the end of their deferral periods.
Others have tried to negotiate with trust-preferred holders to repay debt at a discount, or have sought fresh capital to facilitate payments. Broadway Financial (BYFC) in Los Angeles agreed in March to raise $6 million and repay deferred interest in exchange for delaying the maturity of its debt.
Negotiation may not be an option for banks that have trust preferreds held in pooled or unmanaged CDOs, which make it difficult or impossible to identify the debtholder.
It's common for investors in trust-preferred securities or CDO managers to threaten legal action when a deferral period ends and holding companies are slow to repay, lawyers say. But American is the first case in which a creditor has forced a court-ordered bankruptcy.
The five-year deferral period on American's trust-preferred interest ended in June 2013, according to court filings. Three months later, the CDO managers sued. In April, a Minnesota court issued a judgment for more than $41 million in debt and accrued interest. The investors sued for involuntary bankruptcy days later.
It's a risky decision and it is unclear whether it was made by the companies managing the debt obligations or by the CDO bondholders. Holding company bankruptcies can be expensive, reducing the amount the creditor recovers. They can also spook bank customers, which could damage the franchise value if the bank is sold.
Fortress and Cohen may want to send a message to other lenders, industry experts say.
"The creditors are thinking strategically over their whole portfolio," says Joel Rappoport, a partner at Kilpatrick Townsend. "It shows other banks that may be in the same position what's coming down the pike if they do nothing, and it encourages them to work quickly to come to solution."
That may not have been an option for American. The company is caught between investors that are demanding payment and a regulatory order that won't allow it. American is operating under a 2009 enforcement action that forbids it from paying making any payments on trust-preferred securities without approval from the Federal Reserve Board.
It is unclear what negotiations took place between American and the CDO managers before the bankruptcy filing, or whether the company sought permission to make payments. Representatives for American and Fortress did not respond to requests for comment. A Fed spokesman declined to comment on confidentiality grounds.
What's certain is that American must develop a plan to repay the debt, and a sale of its American Bank of Saint Paul is the most likely option, lawyers say.
The bank, unlike the holding company, is healthy and profitable, having managed an impressive turnaround after losing more than $60 million from 2008 to 2012. It returned to profitability last year, earning $6.8 million, and is well-capitalized, with a Tier 1 ratio of 8% as of March 31.
If the bank enters a bankruptcy auction, the price it fetches could determine if other investors try to force involuntary bankruptcies.
"Whether this strategy is successful will depend on whether the bank is sold at a good approximation of what it would be truly worth in the open market," Rappoport says. "There have been several successful auctions recently, which may have encouraged the creditors to pursue this strategy."
It's also certain regulators will be closely watching how the process affects the bank's health.
"Regulators need to be aware that if a holding company goes into a bankruptcy proceeding it forces changes at the bank," says Paul Lee, a partner at Debevoise and Plimpton. "In the short term it is not problem for a bank, but they have to recognize that some actions that are intended to protect the bank can harm it."
A bankruptcy could lead anxious customers to switch banks, reducing the value of the franchise, he said. That's one of many unappetizing possibilities that the American liquidation raises for other banks trying to fend off demands for trust-preferred payments.
"I hope this is an attention-getter for all the community banks that have Trups and have been kind of sticking their heads in the sand," says Lee Bradley, senior managing director of Community Capital Advisors. "Some banks are acting like their loan customers who are late on their payments and are just trying not to check the mail."