Return of the Fortress Balance Sheet

Many regional and independent banks that survived the Great Recession of 2008u20132009 did so with well-managed capital cushions and little or no subprime exposure. While the U.S. economy seems to be slowly mending, the risk of significant erosion in commercial real estate and commercial and industrial loan portfolios and other economic trends still represent substantial challenges to banking organizations.

In this climate, regulators have been urging banking organizations to essentially become super-well-capitalized or, in other words, to build “fortress balance sheets.” For the reasons explained below, since traditional noncumulative perpetual preferred stock is treated as Tier 1 capital for regulatory capital purposes, this is a type of security that should be considered to improve capital strength.

The large money-center banks successfully tapped the capital markets at the end of 2009 and into 2010. However, the options for many independent, community-based banking organizations have been more limited except for special situations such as those available to very well capitalized banks that wish to acquire failed banks.

Recently, in California, strong regional competitors have rapidly raised risk capital exactly for this purpose. In November 2009, Pasadena-based East West Bancorp, the parent of East West Bank, raised $500 million in a private placement to fund the acquisition of United Commercial Bank. Federal and state banking regulators orchestrated the transaction after closing United Commercial due to loan losses and other weaknesses. At year-end 2009, East West Bank’s leverage capital and Tier 1 risk-based capital ratios were 10.2% and 15.7%, respectively.

The era of the “fortress balance sheet” has returned to the banking industry. Unless a banking organization already has stellar asset quality and adequate loan-loss reserves, along with Tier 1 leverage and Tier 1 risk-based capital ratios approaching 10% and 12%, respectively, adding traditional perpetual preferred stock to the balance sheet offers benefits and few negatives compared to trust-preferred securities or other exotic capital alternatives.

Building a fortress-like balance sheet with a combination of common equity and perpetual preferred stock has defensive benefits, allowing banks to withstand shocks, and also offers offensive deal-making flexibility. While common stock should always be the dominant element of a banking organization’s core capital, banking institutions that expect to be survivors will be well served by adding traditional perpetual preferred stock to their balance sheets. Various attractive features can be added to these securities to improve their attractiveness to investors, including conversion rights, adjustable-rate dividends, registration rights, and equity kickers.

Trust-Preferred Securities Have Lost Their Luster

Commencing in the late 1990s through 2008, many independent banks and bank holding companies (BHCs) augmented their Tier 1 capital by issuing trust-preferred securities (TPS). After 2000, this trend accelerated when the first pooled issuance of TPS occurred, which dramatically reduced the cost to issue such securities. From 1999 to 2008, banking organizations relied extensively on TPS to increase their core capital. As of Dec. 31, 2008, almost 1,400 BHCs had approximately $148.8 billion in outstanding TPS, compared to 110 BHCs with $31.0 billion outstanding in 1999.

Today, as concerns escalate regarding the financial condition of the banking system generally and the number of troubled banks increases, the ability of financial institutions to access capital markets through this vehicle has been severely constrained. Currently, only larger organizations are finding market acceptance of TPS issuances-and, only then, at a prohibitive cost.

Regulatory changes on the horizon and the new financial reality has also tarnished TPS. Effective March 31, 2011, banking organizations that have been relying on TPS and/or cumulative perpetual preferred stock to boost their Tier 1 capital ratios will become subject to the Federal Reserve Board’s revised narrower core (Tier 1) capital requirements that will strictly limit the organization’s restricted core capital elements to no more than one-third of the sum of core capital elements, excluding restricted core capital elements, net of goodwill, less any associated tax liability.

As of March 31, 2011, the core capital elements qualifying for inclusion in the Tier 1 component of a banking organization’s qualifying total capital are common stockholders’ equity; noncumulative perpetual preferred stock, including senior perpetual preferred stock issued to the U.S. Department of the Treasury; and qualifying minority interests relating to common or noncumulative perpetual preferred stock directly issued by a consolidated U.S. depository institution.

TPS are considered restricted core elements of capital and may be included in Tier 1 or Tier 2 capital subject to certain limitations. However, even if federal regulators decide to allow a banking organization to treat TPS as Tier 1 capital, the new normal is that bankers, investors, and regulators have all realized that as the equity capital position of troubled banking organizations deteriorates, the amount of TPS that qualifies for inclusion in regulatory capital declines, accelerating the ratio’s downward slide. This is particularly troublesome for organizations that have made acquisitions and have a significant amount of goodwill.

Traditional Preferred Stock Is Making a Comeback

The federal bank regulatory response to the 2008 financial meltdown and the financial and banking industry turbulence since then, which includes severe loan-quality deterioration, steep declines in asset valuations, and tougher safety and soundness examination standards by all of the federal bank regulatory agencies, as well as many state financial institution regulators, has changed regulatory and market expectations regarding capital adequacy.

While the published banking agency regulatory requirements for well-capitalized financial institutions have not been modified, in practice, the federal banking regulators are requiring almost all banking organizations to hold significantly more Tier 1 capital than the published requirements. In fact, if a banking institution has significant asset-quality problems, the amount of new equity capital necessary to satisfy an institution’s primary federal banking regulator may appear to be virtually unlimited, given ambiguities as to asset values and the need for an adequate reserve for loan losses.

Until late 2008, it wasn’t only the ease of issuing TPS or TPS’s inexpensive placement costs that made traditional preferred stock unattractive. The tax treatment of the dividends paid on TPS, which are tax deductible by the issuer, was more favorable than the tax treatment of dividends paid on preferred stock, which are not deductible as an interest expense. This factor became unimportant when the risk of a global financial meltdown was highest in September 2008 and Congress adopted the Troubled Asset Relief Program (TARP) pursuant to the Emergency Economic Stabilization Act of 2008.

Overnight, perpetual preferred stock became the equity security of choice in the banking industry. Pursuant to TARP, all of the largest financial institutions in the U.S. issued senior perpetual preferred stock (and warrants) to the Department of the Treasury. When the banking industry crisis reached its fulcrum, the Treasury and the Bush Administration concluded that investing billions in perpetual preferred stock issued by the largest financial institutions in the country was the only method to save the industry.

Community and regional banks and bank holding companies can use perpetual preferred stock to fortify their balance sheets, too. Preferred stock can be categorized as either Tier 1 or Tier 2 capital, depending on the provisions that are included in the stock instrument. It is a very flexible type of equity security, and numerous permutations can be created. For bank regulatory purposes, if the preferred stock can absorb losses while its issuer is a going concern, it will typically qualify as Tier 1 capital, provided that it is perpetual (no maturity date), cannot be redeemed at the option of the holder, and does not pay cumulative dividends.

Qualifying Tier 1 preferred stock can offer liquidation and dividend preferences and the issuer may retain the right to redeem the security as long as redemption is subject to the prior approval of the issuer’s primary federal banking regulator (and in certain instances, a bank’s state banking regulator). Preferred stock can be convertible into common stock at the option of the holder and traditional floating rate or adjustable-rate dividends are also permissible (provided they are noncumulative). Equity kickers (warrants) can make preferred stock more attractive to investors, and registration rights can also be offered in appropriate circumstances. In some instances, banking organizations may find that the issuance of nonvoting perpetual preferred stock offers important timing and regulatory advantages because the typical change in bank control restrictions and thresholds do not apply to nonvoting securities.

Markets change quickly and the regulatory climate is exceedingly complex. For this reason, the executive management and directors of banking organizations should consult with qualified investment bankers and bank counsel in connection with regulatory capital matters and structuring, placing, and issuing securities. While much is uncertain in our current economic, banking, and regulatory climate, there is little doubt that banking organizations that build fortress balance sheets during 2010 and 2011 will be the institutions most likely to build long-term value and prosper during the remainder of this decade.