It's unlikely that SunTrust Bank wanted to become a part owner of a small North Carolina bank when it made a $15 million loan nearly three years ago.

But after the 2008 financial crisis and recession, CommunityOne Bank in Asheboro became critically undercapitalized and is now operating under a consent order. Now SunTrust, potentially on the hook for a loan made in June 2008, is trying to salvage a deal that could prove costly if the smaller bank fails.

On Dec. 30, SunTrust agreed to convert half of CommunityOne's subordinated debt into preferred stock, injecting much-needed capital into the Atlanta bank's struggling client. To help protect itself, SunTrust required the community bank's parent, FNB United Corp., to raise $300 million by June 30 or risk defaulting on the loan.

Analysts said SunTrust has probably accepted that it will not make a return on the loan and is best served trying to keep its $2 billion-asset borrower alive.

"From an investor's perspective, the most important objective is for the bank to survive," said Gardner Davis, a bankruptcy lawyer at Foley & Lardner. "Investors would prefer a junior stake in a surviving bank as opposed to a senior stake in a defunct bank."

In a corporate bankruptcy, debtholders typically trump shareholders in the creditor hierarchy. But when a loan was taken out at the bank level and the institution becomes insolvent, the Federal Deposit Insurance Corp. takes seniority over all other claimants.

SunTrust is particularly vulnerable since it lent to the bank instead of its parent. Should CommunityOne fail, SunTrust would have to square off with the FDIC rather than deal with the discretion of a bankruptcy court, observers said.

Some lawyers said that, because of the FDIC's dominant position, SunTrust is in a precarious spot.

"The only way these deals make any sense from a practical standpoint is whether [the borrower has] access to capital elsewhere," said Jerry Blanchard, a lawyer in the financial institutions group at Bryan Cave.

As a bank-to-bank loan "gets into trouble," a debtholder "is kind of like the tail end of the dog," Blanchard said. "If you're the debtholder and the bank fails, you're likely going to get zero" given the FDIC's typically large claims.

Analysts said that many small banks needing capital will likely look first at what debt or other securities can be converted to equity before taking the dilutive step of selling shares in an unfavorable market. Most recent exchanges involved the trust-preferred securities of holding companies.

Data from SNL Financial shows that only one banking company completed a debt-to-equity conversion last year that was unrelated to the Troubled Asset Relief Program.

In March, Zions Bancorp. in Salt Lake City converted $56 million of subordinated notes into common stock, boosting equity by $47 million and creating an $8.9 million after-tax gain.

The remaining six bank and thrift companies that completed exchange offerings converted other securities — mostly trust-preferred shares — into equity.

Those included Superior Bancorp in Birmingham, Ala., which in January 2010 reached an agreement with holders of $7.5 million of outstanding trust-preferred securities to convert them into newly issued common stock, increasing equity by an estimated $6.5 million.

One of the two Superior holders closed the deal, raising $3.2 million. The other deal, involving $4 million of trust-preferred securities, was still pending at the end of the third quarter.

Debtholders rarely agree to exchanges, said Mark Kanaly, a lawyer at Alston & Bird. "Their business is to lend money, not to invest it in a bank's equity," he said.

Kanaly said he was surprised more community banks and debtholders have not yet tried the strategy employed by SunTrust and CommunityOne. Some lawyers agreed that trimming debt first and raising some equity puts a bank in a better financial position when it seeks more capital.

"SunTrust's move makes it more likely that investors will put additional capital into FNB," Davis said.

Blanchard said FNB's consolidated Tier 1 capital ratio of 0.73% at Sept. 30 would also "be one of the many factors that investors will look at."

Whether FNB can raise capital is unclear, but observers said it is likely SunTrust's best hope.

R. Larry Campbell, FNB's chief executive, did not return calls and a spokesman for SunTrust Banks Inc., the lender's parent company, said he would not discuss specific client relationships.

So far, the handful of attempts to work out bank-to-bank loans since the financial crisis have not ended well. Early last year, MidWest Banc Holdings Inc. in Illinois tried to convert an $80 million credit line from Marshall & Ilsley Corp. into equity in hopes of attracting more capital. MidWest's bank failed in May, two months after the Federal Reserve Board rejected the parent company's capital plan.

In 2008, First Horizon National Corp.'s First Tennessee Bank repeatedly restructured and avoided declaring default on a $48 million credit line to Vineyard Bank in Rancho Cucamonga, Calif., giving the borrower extra time to raise capital. Vineyard failed in July 2009.

Kevin Fitzsimmons, an analyst at Sandler O'Neill & Partners LP, said SunTrust has likely written down the CommunityOne loan already.

Of the conversion agreement, Fitzsimmons said, "I don't think it's a positive development for SunTrust, but it is a step in the right direction for FNB."

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