StoneCastle Revives Precrisis Source of Capital

A precrisis investment vehicle has resurfaced, and some of the banking industry's smallest institutions have enthusiastically jumped on board.

StoneCastle Partners, a New York investment firm, recently closed on a $250 million structured investment. The deal, a collateralized-debt obligation that includes subordinated debt from 35 community banks, is being billed as the first of its kind since 2008.

The deal, which promises to breathe new life in what has been a languid market for structured securities, has also raised red flags because, on the surface, it resembles the collateralized-debt obligations that wreaked havoc on banks during the financial crisis.

Industry observers, however, insist that the vehicle — a cheap source of capital for community banks — is a safer bet for investors this time around.

"The differences are huge," Greg Mason, an analyst at Keefe, Bruyette & Woods, wrote in a note to clients. Mason asserted that no "financial engineering" exists, adding that StoneCastle holds all of the credit risk.

The banking industry is all too familiar with specialized products designed to boost capital levels.

Before the crisis, many banks issued trust-preferred securities, a hybrid instrument with a range of tax benefits. More than 1,800 banks issued a total of $38 billion in trust-preferred securities that were purchased by collateralized-debt obligations and then sold in tranches to investors, according to a 2010 report from the Federal Deposit Insurance Corp.

A number of banks issued trust-preferred securities and purchased CDOs. When the markets crashed, major writedowns occurred and a number of banks failed, according to the FDIC. "Evidence suggests that banking organizations that issued [trust-preferred securities] were weaker as a result, took more risks, and failed more often than those that did not," the agency noted in its report.

Policymakers have since changed the way trust-preferred securities are treated under capital rules. Under the Dodd-Frank Act, the securities no longer count as Tier 1 capital. Basel III includes similar limitations.

"Everything had to be rethought" after the crisis, Joshua Siegel, StoneCastle's chief executive, said.

"Capital standards changed, securitization changed," Siegel added. StoneCastle's new CDO "takes off where trust-preferred CDOs left off."

Siegel, meanwhile, doesn't shy away from discussing the similarities between his firm's product and risky crisis-era securities. "The deal is structured at its core to how I started doing them in 1999 when I was at Solomon Smith Barney and Citigroup," Siegel said.

The collateralized-debt obligation, given the name "Community Funding," counts as Tier 2 capital and is structured in two tranches issued by the CDO: $205 million in senior notes, with a 5.75% coupon; and $45.5 million in preferred shares. Citi was the deal's sole manager.

TS Banking Group, a privately held company in Treynor, Iowa, is one of the 35 banks that signed on to the first deal. TS Banking was interested in the CDO because it was looking for a cheap source of capital to fund acquisitions, said Chris Graham, the $593 million-asset company's controller.

"We felt that through this type of transaction we could get similar pricing to a company that has better access to capital markets," Graham said.

TS Banking, which bought the $67 million-asset Farmers State Bank in Crosby, N.D., in January, plans to make more acquisitions in the near future. The company, which issued $12.5 million in debt, may also use the funds to support organic growth and boost Tier 2 capital.

"It was good timing for us," Graham said. "We were going to look for the capital one way or another."

The vehicle is aimed at banks that "don't necessarily fit these sexy stories" of high-growth banks, Siegel said. Most banks that participated are tiny lenders with traditional business models, and several lack access to capital markets because they are privately held or too small to receive a credit rating.

Recent policy changes have sparked a demand for CDOs among community banks, Siegel said. About a third of the initial participants are using the capital to refinance funds received through the Treasury Department's Small Business Lending Fund. (Dividends on SBLF shares are set to jump from 5% to 9% early next year.)

Other small banks have started looking for ways to take advantage of the Federal Reserve Board's recent change to the Small Bank Holding Company Policy Statement, Siegel said. The change, finalized earlier this year, lets holding companies with up to $1 billion in assets take on additional leverage.

Getting nearly three dozen banks on board was a "difficult" process, Siegel said, adding that it required extensive conversations with accountants, regulators and bank executives. Still, StoneCastle hopes to close on another CDO as soon as possible.

"It depends on how many banks show up, wanting capital," Siegel said.