Capital Markets Corner: Subordinated Debt Update

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1 4th Quarter 2016 Capital Markets Corner: Subordinated Debt Update Eight years removed from Lehman Brother s failure and the subsequent Great Recession, the U.S. banking industry finds itself very well capitalized. In large part, this is a function of higher regulatory mandated capital requirements to mitigate excess leverage and avoid another banking crisis. The recapitalization process started with the Troubled Asset Relief Program (TARP), a U.S. government initiative launched on October 3, 2008, to inject preferred stock as Tier 1 capital into the banking sector. This was followed by a second U.S. government capital program called the Small Business Lending Fund (SBLF), which was signed into law in 2010 as part of the Jobs Act. SBLF attempted to spur lending to small businesses by providing cheap Tier 1 capital (as low as 1.00% preferred dividend rate) to community banks with assets less than $10 billion. Many banks utilized SBLF as a means to pay off TARP, while others sought cheap capital as an alternative to raising common equity. As the health of the banking sector improved, these government-sponsored programs provided some much-needed capital to the sector while bridging the gap to private capital. However, while the 1.00% cost of SBLF preferred was attractive to banks, that dividend rate automatically adjusted to 9.00% if not repaid within 4.5 years of receipt, substantially increasing the cost of capital. While some institutions paid off SBLF through earnings, many needed to find an alternative capital source to refinance the preferred stock as the 9.00% cost, below the line, was now very expensive capital. Consequently, the banking industry has experienced a significant increase in subordinated debt as a cost-effective source of capital. continued on page 2 AmbassadorAlert 4th Quarter 2016 Capital Markets Corner: Subordinated Debt Update 1

2 Subordinated debt has been around for a long time but was primarily utilized by very large banks to diversify their capital structure. In addition, subordinated debt capital markets were historically available only to larger issuers since smaller banks didn t have the same access. From a capital perspective, sub-debt receives Tier 2 treatment when issued by holding companies or at the bank level. However, if an issuing holding company pushes it down to the bank subsidiary, it is treated as Tier 1 capital at the bank, just like any other investment from the holding company. As interest rates have remained historically low concurrent with the debt capital markets expanding for smaller issuers, sub-debt for community banks and the entire banking industry has taken on an increased role. To that end, sub-debt issuance really started to expand in 2014 and accelerated meaningfully in 2015, primarily driven by institutions looking to refinance higher costing SBLF. In fact, if we look at banks and thrifts with less than $20 billion in assets, there were 29 subordinated debt deals in 2014, followed by 64 in Issuance was light in the beginning of this year but picked up drastically in the third quarter. There have been 43 deals announced as of the end of the third quarter and we fully expect sub-debt issuance to continue as a primary source of capital for the industry. So what are the key factors that will drive sub-debt issuance into the future? We have highlighted several of the reasons below. Lowers the issuer s WACC: The weighted average cost of capital (WACC) is the rate a company is expected to pay, on average, to all of its security holders to finance its assets. As investors make decisions on what companies they will invest in, they regularly assess and look for institutions that generate returns on invested capital (ROIC) that exceed its cost of capital. In simple terms, a company s ROIC should exceed its WACC (ROIC > WACC). Consequently, the goal of every company should be to maximize ROIC and minimize WACC to the benefit of its shareholders and investors. In regard to a bank s capital options, common equity is the most expensive. Using the capital asset pricing model (CAPM) to determine a bank s cost of equity, it states that the cost is equal to the issuer s beta, multiplied by the market risk premium and then added to the risk free rate. For example, Subordinated debt has been around for a long time but was primarily utilized by very large banks to diversify their capital structure. if a bank has a beta of 1.0 and the market risk premium is 5% when the current risk-free rate is taken into account, the cost of equity would be around 7%. Other capital options like preferred stock, senior debt, and subordinated debt have a cost of capital that is a function of the interest rate associated with the instrument, recognizing that preferred dividends are paid after tax while interest on debt is paid pre-tax. Therefore, lower-cost debt and subordinated debt can meaningfully lower a bank s WACC and improve the delta between ROIC and WACC. Based on where current subordinated debt deals are coming to market, the rate for highperforming banks with assets exceeding $1 billion is between 5.00% and 6.00%. After tax, the cost of this capital is only 3.25% to 4.00%. In comparing this cost to the cost of common and preferred equity (much higher after tax), sub-debt offers an issuing bank a tremendous opportunity to lower its WACC by adding it to the capital mix. For a more in-depth analysis of ROIC and WACC, please see Dr. Walker s article in this newsletter titled Are Your Bank s Returns Exceeding Your Cost of Capital? Diversify the Capital Structure: Related to the above section on WACC, sub-debt offers banks the opportunity to diversify the capital structure. Diversification is a concept we are all familiar with as relates to investing and managing our balance sheets on the asset side. We have been taught not to put all our eggs in one basket because that is not a prudent management strategy. In other words, it is too risky to be overly exposed to one investment, one asset class, etc. That is why banks have fixed and floating rate commercial loans, consumer loans, C&I loans, land and development loans, Treasury securities, agency securities, mortgage-backed continued on page 3 AmbassadorAlert 4th Quarter 2016 Capital Markets Corner: Subordinated Debt Update 2

3 securities, tax-exempt and taxable municipal securities, corporate securities, and more on the balance sheet. Diversification inherently reduces risk, lowers volatility, and assists in generating long-term sustainable and predictable earnings. The same holds true for diversifying a bank s capital structure as the proper mix of equity, preferred, debt, and sub-debt can lower an institution s WACC and create capital structure efficiency. Corporate Finance Decisions: Financial managers are always looking for ways to efficiently and effectively manage their balance sheets. As discussed above, refinancing higher costing legacy capital is one way to do that. In other words, issuing cheaper senior/subdebt or preferred equity to pay off higher costing debt or preferred equity makes sense. As mentioned above, many institutions issued less-expensive sub-debt to pay off SBLF that cost 9.00%. Obviously that is a home run strategy, and there are still institutions with SBLF that have this option. In the current environment, and as long as rates remain low, sub-debt affords banks with additional opportunities to refinance higher costing legacy capital instruments such as senior debt, TruPS, preferred equity, etc. Additionally, bank holding companies also have the ability to issue sub-debt and use some of the proceeds to buy back stock if their respective stock is undervalued and they have the overall capital ratios to support this. Candidly, we believe this could be a significant driver of future sub-debt issuance. Larger companies have regularly issued debt to facilitate stock buyback initiatives that enhance returns on equity (ROE) and earnings per share (EPS). Banks should adopt a similar philosophy and opportunistically take advantage of this corporate finance tool when available and appropriate. Facilitate Growth: For institutions that are looking to grow either organically or through acquisition, new capital is required if target growth rates are outstripping the institution s sustainable growth rate (SGR). SGR is the rate an institution can grow assets at its current ROE without eroding current capital ratios. An institution s SGR is calculated by multiplying the ROE by its retention ratio (1-dividend payout ratio). For example, if a bank has an ROE of 8% and it pays out 25% of earnings in the form of dividends (retaining 75%), then the SGR is 6% (8.00% 75%). In this example, a growth rate in excess of 6% will require new capital in order to maintain current capital ratios. Consequently, banks that have growth prospects that exceed its SGR can turn to sub-debt as an option. Additionally, sub-debt can be utilized to support M&A opportunities to bolster capital levels or fund the cash component of a deal. Enhance Capital Levels: New regulatory guidelines have required banks to operate with higher capital and less leverage. Coupled with newer regulatory guidelines around CRE concentration and growth rates, sub-debt provides an efficient and cost effective way to address any capital shortfalls. Additional Source of Liquidity: Given the current cost of sub-debt from an issuer s perspective (cheap), it can be issued to enhance and bolster a bank s liquidity. While banks have many sources of liquidity (deposits, wholesale funding, lines of credit and credit facilities), sub-debt can augment every bank s liquidity and keep dry powder with its other sources for down the road. Market Expansion: Over the past two-plus years the sub-debt market has expanded meaningfully to the benefit of both issuers and investors alike. The universe/network of prospective investors has grown, which has contributed to driving the cost of capital down for the industry. As interest rates have remained low, investors are starving for attractive yielding assets, which are very difficult to find. On a risk-adjusted basis, single-name sub-debt issues provide extremely attractive coupons and structures (10-year fixed to float) on both an absolute and relative basis. Whether the investors are other banks, insurance companies, asset managers, etc., the asset class provides an attractive alternative relative to other asset classes. (As an aside, we very much like this asset class for banks as an asset alternative within the new regulatory guideline limits. Sub-debt offers asset diversification, attractive absolute and relative yields, and value as a loan surrogate, and banks are investing in what they know.) Over time, we fully expect the market to gain additional participants as it matures and as new investors gain comfort, all leading to further expansion of the market for sub-debt. continued on page 4 AmbassadorAlert 4th Quarter 2016 Capital Markets Corner: Subordinated Debt Update 3

4 In summary, it is our view that banks of all sizes should strongly consider sub-debt as part of an efficient capital structure. As highlighted above, there are myriad benefits to issuing sub-debt that can assist every bank in improving performance, supporting growth, and managing its balance sheet. We believe that sub-debt has staying power, particularly as trust preferred capital is no longer an option, having been disavowed by regulators (legacy trust preferred has been grandfathered in some cases) and as the market has expanded markedly. Currently, the market for sub-debt is as strong as it has ever been given seemingly insatiable demand from the investment community searching for attractive risk-adjusted yields. Markets ebb and flow, so this won t likely always be the case, particularly if and when the Fed raises interest rates. If you are on the fence or considering sub-debt to complement your capital structure at some point, timing is propitious now. And, as always, we stand ready to assist in developing and executing your capital plan. Matthew T. Resch, CFA Josh A. Albright, CFA AmbassadorAlert 4th Quarter 2016 Capital Markets Corner: Subordinated Debt Update 4

5 THE AMBASSADOR TEAM: 1605 North Cedar Crest Blvd. Suite 508 Allentown, PA Executive Blvd. Suite 503 Rockville, MD Chicago Mercantile Exchange 30 South Wacker Drive 22nd Floor Chicago, IL Joshua A. Albright, CFA Allen R. Collins Chief Compliance Officer Arnold G. Danielson Chairman Emeritus, Danielson David G. Danielson Head of Investment Banking Ryan G. Epler Heidi Frey Administrative and Trade Settlement Coordinator Charles Gorman Associate Strategic Analyst Mike Harrison Vice President Karl J. Ostby Investment Banking Robert J. Pachence, Jr. Jack E. Payne, CFA, CFP Finance & Operations John D. Putman Senior Vice President Michael Rasmussen Investment Banking Matthew T. Resch, CFA Jay Shah, CFA Vice President, Capital Markets Eric R. Tesche Managing Director Mark B. Trinkle John S. Walker, Ph.D., CFA Chief Economist Ryan Walker Associate Strategic Analyst Rick Weiss Senior Bank Strategist The information presented is for informational purposes only. This is not an offer or solicitation to purchase or sell any security through Ambassador Financial Group, Inc., a current member of FINRA/SIPC. For more information contact us at Ambassador Financial Group, Inc. Important Disclosure: Ambassador Financial Group does and seeks to do business with companies included in this report. As a result, readers should be aware that the firm may have a conflict of interest that could affect the objectivity of the report.