In early May, the holders of the trust-preferred liabilities of American Bancorporation in Mendota Heights, Minn., forced the company into involuntary bankruptcy. The case is timely because it shows that collateralized debt obligation vehicles, one of the major holders of bank Trups, are finally enforcing their creditor rights. It also raises questions about whether regulators might consider more flexibility in their approaches to preserving bank capital and solvency. Though American's bankruptcy was complicated by several factors apart from regulation, concern is mounting in the banking community that other holding companies could follow a similar path unless banks are given more options for restructuring and avoiding bankruptcy.
By way of background, trust-preferred securities are hybrid instruments that benefit from equity-like treatment for capital calculations but debtlike treatment for interest purposes. So this kind of security is the best of both worlds for the issuer. Part of the logic for equity-like treatment derives from the fact that issuers can defer payments to investors for up to five years in certain circumstances. This ability to defer payment for such an extended period feels a lot like equity. And many Trups issuers have been deferring now for just about five years, meaning that they have to fix the situation by making back interest payments or else go into default. This ability of the Trups bondholders to force default feels a lot like debt.
Three CDO creditors held the American liabilities: Alesco Preferred Funding XV, Alesco Preferred Funding XVI, and Alesco Preferred Funding II. The creditors demanded payment of interest that the once-troubled company had been deferring for many years, and the result was that American filed for bankruptcy on May 1. The deferral window that had allowed the non-payment of interest is now closing for banks, and the creditors are coming.
Crucially for the question of what banks can do now to save themselves from bankruptcy, two of the major bank regulators took different views on Trups. The Federal Reserve was willing to treat them as equity, allowing the bank to count Trups towards Tier 1 Capital reserves. The Federal Deposit Insurance Corp. balked, leading to the following anomaly: Trups at insured depositories are pretty much issued only at the holding company level (regulated by the Fed) rather than at the operating company level (regulated by the FDIC). (For a full discussion, see "The Trust Preferred CDO Market: From Start to (Expected) Finish," published by the Federal Reserve Bank of Philadelphia.)
The problem is that, in certain cases, regulators are refusing to allow banks to use excess capital reserves to satisfy their Trups obligations, potentially resulting in regulator-driven default of an otherwise healthy, or at least salvageable, institution. That doesn't appear to have been the case in the American bankruptcy, but industry sources are telling us that regulators have been reluctant to let a well-capitalized bank use excess funds to shore up the finances of its holding company. So the consequence of the initial regulatory split is that the problem is in one part of the bank, but the solution is in another part of the bank. The solution cannot be brought to bear on the problem.
The Trups market is now hitting crunch time because the deferral grace period only lasts for five years. Several hundred regional banks are potentially becoming subject to bankruptcy proceedings if the Trups creditors decide to enforce their rights, but some find themselves caught in a Catch-22. Because it is the bank that generates cash while it is the holding company that owes the back interest, cash needs to be transferred from the bank to the holding company to satisfy the debt, even though they are for practical purposes the same entity. But because the general rule is to disallow the up-streaming of cash to the parent for the payment of dividends (remember the holding company treats Trups as equity), no cash is available even in cases where the bank has excess capital reserves.
The result may be that some banks with sufficient capital to make good on their loan obligations will be forced into default in other words, an action ostensibly taken to strengthen the bank (holding excess cash to improve the capital position) may end up bankrupting the bank through the holding company. Yet the Fed and FDIC seem curiously unconcerned about this scenario.
There are several possible reasons for this indifference. It may be the regulators have not observed this type of forced bankruptcy to date, and so inertia wins the day. It may be they believe actually that Trups creditors will not try to enforce their rights. This is where the American case could be so instructive.
It may also be that they are focused only on preserving capital ratios at the operating bank level, and will not approve any transaction that involves using part of that capital to pay liabilities at the holding company level. If this possibility is really motivating the government, then banks will not get recapitalized at the holding company level. Some of them will be forced into bankruptcy since the five-year deferral period is now ending. The end result of this process will likely be acquisition by larger banks. Consequently, small banks that could possibly have recapitalized will be rolled into superregionals, and smaller banks will go away.
End result? Fewer, bigger banks. Is that what the government wants?
Dave Jefferds is co-founder and chief operating officer at DealVector in Sausalito, Calif. DealVector runs an online platform that connects investors in fixed-income or distressed debt with other participants in deals.