We have issued literally dozens of client alerts since the crisis in banking became acute in the fall of 2008. Despite the torrent of information that has already been provided, there are a number of issues that have flown below the radar or need further clarification. We have attempted to address some of these below.
There have been several developments regarding the regulatory and market reaction to liquidity issues.
Wholesale funding has become a negative term, and, unfortunately, the regulators have been painting with a broad brush. In a number of the almost 40 bank failures since the start of 2007, the failed institution had a high portion of funding from brokered deposits and Federal Home Loan Bank advances. Some of these banks were relatively new players that had entered banking after the “dot.com” meltdown with the strategy of using brokered deposits to fund a niche lending program. In other cases, the banks employed aggressive growth strategies that relied heavily on wholesale funding. Because the bank regulators have seen that wholesale funding has often been quick to flee a deteriorating bank, the FDIC, in particular, has strongly discouraged the use of wholesale funding by financial institutions altogether, regardless of condition.
If a bank becomes less than “well-capitalized” under the Prompt Corrective Action (PCA) standards, its wholesale funding eligibility is severely limited or even prohibited. If a bank enters into a formal administrative action, then the regulators can drop its capital rating one level on the PCA scale. Thus, a bank that would otherwise be well capitalized would be deemed to be only “adequately capitalized” if its primary federal regulator places it under a supervisory order. This circumstance then triggers the application of the brokered deposit limitations.
In light of this combination of factors, banks, even high-performing institutions, have been reluctant to push back against examiners who advise them to reduce their reliance on wholesale funding. Obviously, this has had national ramifications because it limits a free flow of funding where it would do the most good to spark new lending.
FDIC Proposed Action on Interest Rates
The FDIC has recently issued a statement noting its broad authority to establish limits on the interest rates that a financial institution can pay. The statement reads as follows:
[S]ection 29 [of the FDI Act] authorizes the FDIC to impose by regulation or order such additional restrictions on the acceptance of brokered deposits by any institution as the [FDIC] may determine to be appropriate . . .. [T]his broad grant of authority does not refer to capital categories (emphasis added).
Thus, the FDIC could adopt additional restrictions on the acceptance of brokered deposits without regard to a bank’s capital rating under PCA. To date, the FDIC has not adopted any such additional restrictions, but it is soliciting comments on whether the adoption of such restrictions would be appropriate. In effect, the FDIC is requesting whether it should impose a rate cap on the amounts that all financial institutions can pay for brokered deposits. Comments were due on the proposal on or before April 6, 2009.
The FDIC proposes to establish a “national rate,” which would be calculated and published by the FDIC. The FDIC has said that rate will be a simple average of rates paid by all insured depository institutions in branches for which it has available data. The FDIC will define a market area as any readily defined geographic area in which the rates offered by one institution will affect the rates offered by other institutions operating in the same area. The FDIC will presume that the rate in any market is the average national rate unless it determines, based on available information, that the average rate in that market differs from the national rate.
In short, for institutions that are less than well capitalized, they will be required to pay a rate that is no more than 75 basis points higher than the national rate, unless an institution can overcome the FDIC’s presumption that the national rate will also be the local rate. This restriction is in addition to the restrictions on brokered deposits for adequately capitalized banks or banks that are in a lower capital category under the PCA rules.
On October 14, 2008, the FDIC announced the Temporary Liquidity Guarantee Program (TLGP). The TLGP enables financial institutions to issue senior unsecured indebtedness with a government guarantee. Initially, it was hoped that the FDIC would also afford that guarantee to holding companies to enable them to add capital to their subsidiary banks. Recent FDIC pronouncements have indicated that the TLGP guarantee will be extended only to bank holding companies on an extraordinary basis.
Banks can, however, issue senior unsecured indebtedness equal to 2% of their liabilities as of September 30, 2008, provided that they had no senior unsecured indebtedness on that date. (Otherwise, the limit is 125% of the amount of senior unsecured debt outstanding as of September 30, 2008). The FDIC guarantee extends until December 31, 2012, but the debt must be issued before October 1, 2009.
The indebtedness guaranteed under the TLGP is not considered wholesale funding. In addition, unlike a CD, if rates increase, the noteholder under the TLGP cannot pay a penalty and reclaim its money. In response to the TLGP, we are aware of at least six placement agents that would be willing to assist financial institutions in issuing such indebtedness. The pricing on this type of funding is generally based on the three-year Treasury rate or three-month LIBOR. The all-in cost for such issuances tends to be 350-375% (this includes the FDIC’s 1% special assessment).
We have negotiated agreements with a variety of these placement agents. The funding received is obviously a commodity to the issuing bank. Accordingly, it is important to be mindful of differences in placement agents, trustee fees and the overall costs of issuance.
In addition to wholesale funding, the regulators are revisiting issues that they have not stressed since the early 90s.
Real Estate Appraisals
The regulators are once again scrutinizing appraisals supporting collateral values and other real estate owned. The appraisals are being evaluated for staleness and also to determine whether the comparables are appropriate. The examiners are also looking into whether banks have an appropriate appraisal review process. Banks should, therefore, review these processes prior to the next examination to ensure that they will pass muster with the regulators.
The bank examiners have been scrutinizing bankers’ compliance with the loan-to-value (LTV) requirements. Recent examination reports have also criticized banks for failing to track LTV ratios in excess of the supervisory limits and report such exceptions to the board of directors. Other criticisms in regard to the LTV requirements include:
- basing analysis off of the funded balance only, rather than the total loan commitment,
- reporting LTV ratios in excess of bank policies, without also noting exceptions to supervisory limits,
- failing to limit the value used to calculate LTV ratios for real estate to the level of cost or appraised value, and
- failing to track the aggregate volume of loans in excess of LTV requirements as a percentage of capital in order to ensure that the aggregate level of exceptions is consistent with the requisite minimum.
Texas Delinquency Ratio
Texas examiners are calculating Texas banks’ delinquency ratios to determine whether the banks’ deterioration warrants an administrative action or further scrutiny. The Texas ratio equals the sum of nonperforming assets and 90+ delinquent loans divided by the sum of Tier 1 capital and the allowance for loan losses. Bankers should be mindful of this and place even greater emphasis on monitoring delinquencies.
The bank regulators have begun to focus on the quality of a bank’s capital, rather than just the mathematical application of the ratios. Examiners are instructed to consider the source of the capital and whether there will be lender or investor pressures on the holding company that might render the capital that had been injected less than permanent.
The rating agencies are also considering that issue. For instance, Moody’s had said that capital coming into a new organization from TARP is not as reliable as other sources of capital. Moody’s treats TARP funds as 25% equity and 75% debt for the purpose of its calculation of tangible common equity. Although A.M. Best takes a similar approach, it has said it will consider the capital of the companies taking TARP funds on a case-by-case basis.
Subchapter S Developments
On January 15, 2009, the United States Tax Court ruled in favor of the IRS in a case involving the 20% TEFRA disallowance. The question presented was whether the TEFRA disallowance phases out after a financial institution has been taxed under Subchapter S for three years. The Tax Court determined that the 20% TEFRA disallowance continues even after three years. For more information, see the upcoming issue of ICBA’s Subchapter S: The Next Generation newsletter that we co-edit with RSM McGladrey.
Subchapter S banks that elect to issue debentures to the U.S. Treasury (UST) under TARP will also be required to provide the government with a warrant for additional debt representing 5% of the securities received by the UST. The warrant will be exercised immediately and will bear interest at a rate of 13.8% from the date of issuance.
The UST is paying only for the initial debentures (the warrants will have a nominal exercise price). Accordingly, the price paid for the debentures will be allocated between the debentures the UST purchases and the warrants exercised by the UST. This creates the possibility of original issue discount (OID) for tax purposes. As a result, the bank holding company issuing the debentures and warrants to the UST may be able to receive an additional interest deduction taken over the life of the debentures.
These are only a few of the recent developments affecting banks. We will follow up with additional client alerts and newsletters as important new issues surface.