Trends And Tactics In Finally Paying Off TARP

Article by Daniel F. Wheeler and Justin C.R. Evans

Originally published March 24, 2011

Banks generally have several reasons for wanting to exit TARP, including the substantial cost of the 5% pre-tax dividend rate (rising to 9% in 2-3 years), restrictions on dividends and buybacks and potential liability for improper usage or disclosures relating to TARP. This article describes some tactics banks have used in paying off TARP and some of the results to date.

Raise private capital.

The dominant means of achieving regulatory approval for TARP repayment has been a concurrent capital raise. Regulators generally insist that common equity be the primary form of capital and that the total capital raise be at least 25-100% of the amount of the repaid TARP investment. Trust preferred offerings are generally unavailable and, under the provisions of Dodd-Frank, future issuances will only count as Tier 1 capital for banks with less than $500 million.

Most community banks are shut out from the debt market. Nationwide, only 4 debt offerings have been completed for banks and thrifts with less than $1 billion in assets since the start of 2010, with aggregate proceeds among those issuances of just $20 million. Pricing for these transactions has typically been in the 9.00 – 9.25% range and debt does nothing to satisfy regulators' demand for more tangible common equity.

Currently, bank management teams feel intense pressure from their staff and shareholders to once and for all escape the restrictions on dividends and buybacks and the continued drain on earnings. However, equity offerings over the past two years have typically permanently diluted the long term earnings per share available to existing shareholders. This is even more evident in situations where the offerings were completed at a discount to the bank's per share book value. Investors have been intensely focused on expected loan losses and thus, a focus on substantiating and defending the bank's asset quality and resulting book value is frequently the most effective action in raising the issuance price per share. At a minimum, bank management should carefully document the reasons for a new offering and the price at which it does so. This will help minimize the risk of a shareholder lawsuit claiming a management conflict of interest.

Combine with another institution.

A selling institution should closely compare its likely valuation in an acquisition to the dilutive effects of a capital raise. Not all banks that can raise new capital on affordable terms can produce sufficiently attractive returns on that capital. A sale may also be the best alternative for institutions that don't foresee an attractive means of raising capital through the next several years. Targets possessing strong profitability, attractive growth prospects, scarcity value and a de-risked loan portfolio will achieve premium valuations.

An acquisition by a non-TARP bank can result in severance payments that would not be possible at the target institution under TARP rules. Buyers are not required to repay TARP, although they typically choose to do so. A carefully negotiated and documented acquisition that complies with all corporate governance rules should not be attacked by Treasury as an attempt to subvert pay restrictions.

Convert TARP preferred stock into common stock.

Banks can attempt to convert the TARP preferred stock into common equity. This eliminates the TARP dividend but makes the government a significant shareholder in the bank. This is generally only a viable option for those institutions that (1) would fail without new capital, (2) concurrently raise a substantial amount of new capital to restore the capital ratios and (3) could only attract such new capital if the Treasury agreed to a discounted conversion. Banks with stock only traded over the counter are usually too thinly traded to assure Treasury that it could dispose of its common stock received upon conversion.

A successful exchange was recently completed by Central Pacific Financial Corp. in Honolulu, which exchanged the Treasury's $135 million TARP investment for common stock concurrent with a substantial capital raise. Due to the weakened financial condition of the institution, the Treasury agreed to accept common stock valued at 37.5% of the original preferred stock value plus accrued and unpaid dividends. The Treasury's warrant was amended to reflect an exercise price equal to that price.

Use existing funds or assets.

For much of 2009 and 2010, asset sales were non-existent as market clearing prices between buyers and sellers could not be established. However, since late 2010, the market seems to have found a clearing price for assets of many types. For banks carrying assets that are appropriately marked, a sale of assets could boost capital ratios and reduce the amount of capital the bank needs to raise. Strong banks may be successful in redeeming the TARP investment out of existing capital if they are strategic in convincing their regulators that their remaining capital levels and liquidity are sufficient.

Refinance under SBLF.

A popular method of repaying TARP is to essentially refinance that obligation under the Treasury's Small Business Lending Fund (deadline March 31, 2011). To obtain SBLF financing, all outstanding TARP preferred stock securities must be redeemed and outstanding dividends paid. TARP warrants may remain outstanding. If Treasury requires the bank to raise separate, subordinated matching funds, those must at least equal the SBLF funding and be received by the time of the SBLF funding.

A bank must increase its qualified small business lending or the bank won't receive the benefit of SBLF's lower dividend rates. SBLF uses a different definition of small business loans than the one used in call reports and the guaranteed portion of SBA loans is excluded from the calculation of small business lending for SBLF purposes.

Dealing with warrants.

Valuing TARP warrants remains a thorny issue. After repaying Treasury, a bank has about 2 weeks to decide whether to buy back the warrants or let Treasury auction them off to the highest bidder. Banks will want to study auction results for warrants at similar banks and negotiate a price that is as low as possible, while mindful of the expected auction price. Treasury will be weighing the bank's proposed price against the expected value Treasury could receive in an auction. A recent example is Fifth Third Bancorp's repurchase of its warrant. That transaction priced the warrant at almost a 50% premium to the closing stock price. So far, the interest of investors in Treasury auctions of warrants has been highest in auctions involving smaller banks with comparatively few warrants available. Banks who are thinking about bidding on their own warrants have to balance the appeal of buying their warrants on the cheap with the risk of setting a lower "market" price for the bank's shares than is desirable to the bank's existing shareholders and the bank itself.

Daniel F. Wheeler is banking regulatory partner at the law firm Buchalter Nemer.
Justin C.R. Evans is a Director in the Financial Institutions Group at RBC Capital Markets.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.