CDO Revival Led by Funds Pinning Hopes on Smallest Banks

  • Two deals in the works bundle unrated subordinated debt
  • Products are reminiscent of the TruPS CDO craze of the 2000s

Joshua Siegel is bringing back a version of one of the most toxic financial vehicles ever devised and arguing that this time it’s going to be different.

His StoneCastle Financial is among the funds that are reviving the collateralized debt obligation, or CDO.

CDOs stuffed with mortgages and their derivatives caused billions in losses around the world during the 2008 crisis. The CDO that StoneCastle put together is another kind. It’s backed by subordinated debt issued by about 35 community banks, some of them so small they don’t have credit ratings. Subordinated debt is generally the last type of debt paid off in a bankruptcy, so issuers typically compensate buyers with higher yields than on other borrowings.

Citigroup Inc., which completed the $250 million deal for New York-based StoneCastle this month, calls it a collateralized loan obligation, but it’s a structured security that walks and talks like a CDO. Moody’s Investors Service plans to give it a rating of A3, six grades below Aaa, according to people with knowledge of the deal. Bank bonds rated A typically yield 2.5 percent. Through the wonders of financial engineering, higher-yielding assets were pooled together and sliced into securities with varying risk, allowing StoneCastle’s Community Funding CLO to offer its notes to yield 5.75 percent.

“A CDO is just another word for financing,” Siegel said in an e-mail. “What matters are what assets are being financed.”

This isn’t the first time Siegel pooled small-bank debt into a structured financial product. At Salomon Smith Barney in the late 1990s, he proposed bundling banks’ trust-preferred securities, a predecessor to subordinated debt, into so-called TruPS CDOs. StoneCastle says the underlying securities in its new product rank higher in the capital structure than TruPS.

Geographic Diversity

In a 2001 research report, Siegel divided the U.S. into five regions and wrote that the geographic diversity of the banks whose TruPS he used -- picking debt from different areas -- would make the CDOs safer.

Sales of new TruPS CDOs multiplied in the next seven years by a staggering 7,722 percent, rising to issuance of $60 billion by 2007, according to the Federal Reserve.

In all, Siegel said he put together about 13 TruPS CDOs. “There was a cult following,” he said.

But banks failed all over the country in the 2008 credit crunch, throwing shade on Siegel’s original theory about regional diversification. Larry Cordell, a vice president at the Federal Reserve Bank of Philadelphia, said that’s because too many banks’ portfolios were concentrated in real estate and mortgages. They weren’t diversified enough, he said. The market for TruPS CDOs collapsed as the U.S. mortgage crisis led to a jump in bank failures, causing prices for the securities to plunge. In 2008, Moody’s downgraded bonds in more than 40 percent of the market, according to Cordell. And because banks were able to defer payments on their TruPS, some investors are still waiting to be repaid.

Today’s CDOs are a better bet because the banks have learned from the credit crunch. They’re stronger, with more capital and better regulation, Siegel said in an interview. The CDOs also use less leverage and have shorter maturities, he said.

Because of tougher capital requirements and tighter oversight in the wake of the 2008 crisis, widespread bank defaults would seem less likely, said Ricardo Diaz, head of fixed income for Atlanta-based investment manager FIG Partners.

TruPS issuance has fallen to zero while publicly traded banks sold $12.3 billion of sub-debt, as it’s called, in 2013, about four times what they issued between 2009 and 2012, according to SNL Financial.

Brett Jefferson, president of Hildene Capital Management in Stamford, Connecticut, said that sub-debt CDOs are simply a retooling of TruPS CDOs.

“It’s a flavor of the old deals,” Siegel said. 

TARP Exits

The popularity of sub-debt among smaller banks has been sparked partly by the U.S. Treasury Department’s Small Business Lending Fund. Starting next year, banks remaining in the program will see their rates jump to 9 percent from a borrowing rate of as low as an initial 1 percent. The fund loaned $2.7 billion to 137 community banks, which were supposed to use the money to increase their small business lending. Instead, many of the participants used it to pay off debt from the Troubled Asset Relief Program, according to TARP’s special inspector general.

The Fed is also doing its part to make sub-debt attractive to banks. Aside from low interest rates, the central bank has said sub-debt can be categorized as regulatory capital, the cash cushion all banks need to keep to stay in compliance post-crisis regulations. And the interest is tax deductible for the smallest banks.

Another sub-debt CDO is being put together by Emanuel “Manny” Friedman, co-founder and chief executive officer of EJF Capital in Virginia.


EJF’s CDO would be tied mostly to recently issued sub-debt of community banks and bank holding companies for more than 20 community banks, according to people with knowledge of the offering.

The strength of the securities rests on bank credit profiles that EJF, underwriter Sandler O’Neill & Partners and Moody’s, which is rating the deal, are not broadly disclosing.

EJF didn’t return calls and e-mail messages seeking comment. Calls to Angel Oak Capital, which is helping to pool the underlying assets, were not returned. Sandler O’Neill declined to comment.

Moody’s plans to rate the senior notes Aa2, two levels below its highest grade. Moody’s spokesman Thomas Lemmon said a strength of the transaction is that EJF and Angel Oak are retaining the most risky 20 percent of the deal -- similar to the 18 percent that Siegel said StoneCastle was retaining of the Community Funding CLO.

“All the ingredients are there for it to expand into a larger market again,” Siegel said. However, there’s “no way to know if this market picture will continue,” he said.

(Corrects to add context in third, fourth, sixth, 10th and 11th paragraphs and additional comment in last paragraph of story originally published Oct. 20.)

(Corrects to add context in third, fourth, sixth, 10th and 11th paragraphs and additional comment in last paragraph of story originally published Oct. 20.)
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