By Ray Birch
DETROIT—While the use of subordinated debt has been increasing in credit unions, one lawyer believes not enough credit unions understand the option, which is preventing many more CUs from using it.
“Sophisticated credit unions are using subordinated debt to safely grow organically and non-organically. In the past couple of years you can look back and see so many examples of this, and to date the facts show it has been very successful,” said Michael Bell, a partner and chair of the Financial Institutions Practice Group at Honigman, LLP.
Bell pointed to the growth of subordinated debt among cooperatives in recent years even as misunderstandings remain.
“While it has become much more common, I still feel there is a lot that is still unknown to many credit unions about subordinated debt,” said Bell. “There are credit unions out there that could—and should—issue subordinated debt right now. It would be good for them, but they really don’t know enough about it.
“Several weeks ago, a leader from a very large credit union ran into me and I mentioned something about subordinated debt purchasing, and he said he didn’t know much about it,” continued Bell. “But when I explained more about it, the CEO decided it was a worthwhile growth platform for the CU to begin considering. I see a lot of that happening today.”
Purpose of Subordinated Debt
Michael Macchiarola, CEO, at Olden Lane Securities in Princeton, N.J., is among those involved as credit unions deploy subordinated debt. He reminded that at a credit union subordinated debt is intended to provide an alternative for capital beyond a credit union’s retained earnings, and can be used to support additional growth in lending and financial services, as well as to absorb potential losses.
“Subordinated debt can be used to help credit unions grow at rates that exceed the pace at which they retain earnings. It is also useful as triage capital, where it can be deployed to plug a hole or assist a turnaround plan,” Macchiarola explained.
Macchiarola added subordinated debt can also be used for capital when it comes to acquiring banks.
“The issuance of subordinated debt offsets the dilution of net worth experienced in a transaction and further positions the credit union to build on its capital base,” he said. “It can also be used as defensive capital. Popular during the pandemic, the capital is issued to provide a boost to net worth and offset the deterioration of capital ratios driven by the deluge of stimulus-related deposits.”
Two Camps
“Today, those credit unions interested in subordinated debt fall into two camps. The first group is looking to deploy the capital as part of an acquisition strategy that will be dilutive to capital ratios,” Macchiarola said. “The second group is seeking an NCUA approval and will raise the capital opportunistically, depending on movements in interest rates and business prospects.”
Dan Prezioso, a partner at Olden Lane Securities, told CUToday.info investor attitudes are changing.
“With the challenging environment for liquidity, investors in this asset class have been more discerning, becoming stingier on pricing and pickier about the credit quality and business prospects of the issuer,” Prezioso said. “We expect this market to open up once the rate volatility subsides. In the meantime, potential issuers continue to seek approvals to maximize their optionality.”
Avoiding a ‘Grave Error’
Michael Bell
According to Bell, with the growing size of issuances, he has watched as the asset class has been opening to investors outside of the credit union industry.
“We are seeing community banks and insurance companies come to the table and looking to make investments in credit union subordinated debt,” Bell said. “This helps keep pricing competitive and also provides some nice risk dilution in the eyes of the regulators.”
Bell believes the answer for many credit unions is to simply learn more about subordinated debt and then determine if it fits with the organization’s plans.
“I think the grave error, the biggest mistake, is if in the in the management meetings, in the boardrooms, if you haven't at least learned about this…That's the mistake,” he said. “I say this simply because subordinated debt is an option. It's relevant in the industry. And though it's probably not perfect for everyone, I do believe either issuing or buying is likely correct for a great majority of the credit unions.”
Where to Find More Information
Bell noted many securities firms will help credit unions better understand subordinated debt, its potential uses and fit within the organization.
He added state leagues often have information, as well.
“I would say to a credit union today to look at your investment portfolio. Look at what's available to you on yields. And then think about if you were a purchaser of subordinated debt,” Bell said. “You simply have to learn and decide. But, I think to stick your head in the sand on this is a mistake. Subordinated debt and its use among credit unions has remarkably changed in the last ten years. At one point it was a tool used by the very small, perhaps not the healthiest, credit unions to prop themselves up. It was almost like a charitable situation.
“That situation has actually flipped on its head today. Subordinated debt is being used by the largest, most dynamic credit unions so that they can keep supporting their organic and non organic growth,” Bell added. “It's a completely different vehicle.”