When the COVID-19 pandemic began taking an economic toll in the United States in March 2020, it would have taken a pair of seriously rose-colored glasses to look into the future and predict that the banking industry would be mostly sitting pretty. But that is what happened, at least through the end of the year.
Unlike the previous economic crisis just over 10 years ago, and the recessions that preceded it, the current downturn has mostly spared the banking industry. Indeed, though it is not necessarily reflected in the share prices of publicly traded institutions, many US banks have strong balance sheets and are poised for growth. And that includes community banks. In the words of Fred Lewis, president and vice chair of Northshore Financial in Duluth, Minn., “challenges and opportunity often go hand-in-hand.”
So how can small bank holding companies and their subsidiary banks increase capital levels to address both organic and strategic growth? Economies ebb and flow in business cycles, along with a host of economic data that rise and fall with the times, including interest rates. Every so often these dynamics line up to make a particular form of debt attractive to small BHCs, and right now stars have aligned for subordinated debt (otherwise known as sub debt). BHCs across the country are issuing this somewhat obscure form of debt at rates that many observers haven’t seen in years.
Sub debt is so named because it is subordinate to, or junior to, more senior loans or securities. This means that the purchaser of sub debt stands behind other forms of debt in the case of borrower default—everyone else gets paid first. In other words, sub debt holders often are left holding the proverbial bag if an issuer, for example, files for bankruptcy. (The one exception are equity holders, who are the last in line if the issuing firm is publicly held.)
Given this risk, sub debt issuers have to pay an interest rate that is attractive to potential sub debt buyers, or creditors. It is this cost of issuing sub debt—the interest rate that must be paid—that largely drives market activity. In a low interest rate environment that is all but guaranteed by the Federal Reserve for the near term, sub debt becomes an attractive option for BHCs to increase their capital base.
So, what would a sub debt issuance look like for a small BHC? Scott Martorana, executive managing partner of FinPro, Inc., in Gladstone, NJ, offers a simple descriptive scenario. A BHC may offer $10 million in sub debt, paying an interest rate of 5 percent. This means that each year the BHC will owe $500,000 in interest payments to debt holders. To ensure that it has those interest payments available, the BHC will want to hold, say, about 18 to 24 months of interest payments in reserve; let’s call it $1 million. That allows the BHC to hand off $9 million to its subsidiary bank, which shows up as equity capital on the bank’s balance sheet. “That $9 million will then support additional growth at the bank level,” Martorana said, “or if you are anticipating loan losses, or whatever you need capital for, you now have that $9 million at the bank level.” To that point, if we assume an 8 percent leveraged capital ratio, the bank could conceivably grow by $112 million.
In reality, many BHCs are paying lower rates than 5 percent, a fact that is driving many to the sub debt market. One interesting note about those BHCs, according to Martorana, is that the sub debt is only debt they hold; that is, the debt is subordinated in name only—there is no senior debt on the books. These BHCs, in other words, are in good shape.
Another common element of sub debt, according to Adam Maier, attorney at Stinson LLP in Minneapolis, is that many of the purchasers of the debt are other community banks, along with other accredited investors. That was certainly the case for Lewis and Northshore Financial of Duluth, which issued $15 million of sub debt at 4.75 percent this summer and was oversubscribed within 24 hours—all to community banks. “These aren’t shadow banks,” Lewis said of the investors in sub debt. “This is about community banks supporting other community banks.”
Maier, like Martorana, has seen an “inordinately high” number of sub debt deals this year, and said a BHC often considers such a move for three reasons:
- To strengthen its capital position, especially in light of uncertainties within its loan portfolio caused by the pandemic.
- For organic growth. “They may see a lot of opportunities with their communities and they want to make sure that they have the capital available to increase their loan portfolio,” Maier said.
- To grow strategically. There may be possible acquisitions within their regional markets, Maier said, and BHCs will want capital available “to pounce on those opportunities when they come up.”
Organic and strategic growth were strong motivators for Donald Gibson, president and CEO of Greene County Corp. in Catskill, NY, which issued sub debt for the first time in 2020 (a $20 million issuance). There has been lots of M&A activity in Greene County’s region, Gibson said, and his institution has benefited from that activity, to the tune of 12 straight years of record income growth. “We’ve been fortunate,” Gibson said, and strategic, taking advantage of M&A activity to secure its own opportunities.
Like Northshore, Greene County also sold its debt to other community banks, and Gibson echoes Lewis’s motivation: “If we’re going to pay out 4.75 percent, it might as well be to the benefit of other community banks,” Gibson said. He calls those fellow banks “allies,” noting that the decreasing numbers of community banks in recent years means that they need to stick together and support each other.
It is hard to gauge how much sub debt has been issued by community banks, as national data are not aggregated and many deals go unreported, but Martorana and Maier both note that activity within their firms is unusually high, and even a cursory review of news releases and media stories would affirm that observation. While we do not know the full extent of sub debt issuances, according to S&P Market Intelligence, from May through August of this year there were 66 reported sub-debt issuances totaling $3.9 billion. During the same period in 2019, there were just 13 issuances totaling $832.5 million.
How should a BHC go about investigating sub debt? Most importantly, according to Chris Floyd, president and CEO of First National Bank of Syracuse in Syracuse, Kan., is to “surround yourself with good advisors.” That expertise usually comes from outside the organization and from firms that specialize in such deals. If a bank has a strong team, a good loan portfolio, and a solid plan for growth, it should have success, Gibson said. The process of issuing sub debt is not necessarily difficult, Gibson and others noted, but outside expertise is likely essential.
However, before making a move to sub debt, BHCs and their boards of directors need to engage in a sort of internal due diligence, according to FinPro’s Martorana. “They need to understand why they need the sub debt,” he said. “You don’t raise sub debt just to raise it.” And you don’t raise more than you need, he added, otherwise you are just adding costs. Maier of Stinson LLP echoes that advice. “It’s [sub debt] a market that any sized bank can play in, but have a good story to tell. Investors want to know that you are poised for success.”
While the times may be right for BHCs to consider sub debt, there is always the possibility of storm clouds forming on the horizon. However, to the surprise of many, those storm clouds have not yet appeared. “I thought we were going to be dealing with enforcement orders and prompt corrective action and all the things that happened 10 to 12 years ago,” Maier said about the beginning of the pandemic-driven recession. But he is optimistic. Bank balance sheets and loan portfolios are strong, interest rates persistently low, and banks seem both poised for growth and prepared for another economic downturn, if it arrives.
Gibson’s biggest fear concerns the small businesses in his region and whether the local economy experiences another shutdown. Many, especially those businesses within service industries like restaurants and hotels, will likely close in such a case. Most have survived thus far, he said, but they cannot go on like this forever. “It’s frustrating and scary for them because they have no control over these events,” Gibson said.
Lewis agrees, and adds commercial loans to the worry list. If the recovery lags or another downturn hits, will commercial loans sour? Will future aid from the federal government, if it arrives, continue to serve as a bridge to better days? While Lewis offers no answers to these questions, he is hopeful about the prospects of businesses in his northern Minnesota region—at least for now.
These concerns may actually fuel more sub debt issuances into 2021, according to Martorana, referring back to the first reason that BHCs may consider such debt: defensive capital. “Everyone in the country expects there will be more delinquencies and loan losses later this year and into next year,” he said. Loan forbearances and other programs have delayed this phenomenon, Martorana said, but it’s coming.
When the economy does soften further — if it does — and when banks’ portfolios are challenged—if they are—then sub debt may provide an affordable capital buffer to weather the storm. In the meantime, in a period of organic and strategic growth for many BHCs, sub debt may also offer an efficient opportunity for BHCs to strengthen their positions. Either way, according to Maier, BHCs will want to have capital “ready to go.”
David Fettig is a freelance writer, a former communications executive with the Federal Reserve Bank of Minneapolis, and a former editor of BankBeat magazine.
This article originally appeared in the Fourth Quarter 2020 edition of Bank Owner magazine.