Tarp Dividend Spike Could Spur Community Bank M&A

The Troubled Asset Relief Program, though in wind-down mode, still has the potential to weed out many struggling community banks.

Banks that still hold Tarp capital are bracing for an upcoming spike in the dividend rate. The most troubled banks are likely discussing options that include selling, while healthier banks are still looking for an exit that would let them remain independent, industry experts say.

"As you couple rate increases with increased compliance costs, banks that might not otherwise have thought about M&A might be thinking differently," says Nadine Mirchandani, Americas Financial Services leader for transaction advisory services at EY, an advisory firm. "All of that makes mergers more attractive."

Most banks are paying a 5% dividend on preferred shares issued under Tarp, though the rate jumps to 9% five years after the shares' issuance. This spike will begin in the fourth quarter for the program's earliest participants.

More than 140 banks and thrifts still hold roughly $10.6 billion in Tarp capital, says Michael Iannaccone, president and managing partner at MDI Investments, a bank advisory firm.

Those "sitting in boardrooms are talking about Tarp," says Craig Miller, a partner and co-chair of the financial services and banking practice group at Manatt, Phelps & Phillips. "They are looking at strategic options. If a board isn't, then it is not doing its job."

Nearly two dozen Tarp banks have low capital levels that make it difficult to repay the funds, Iannaccone says. Many of those banks have also lost money in recent quarters, and have taken hits to their returns on average assets, he says.

A number of banks will eventually need to repay dividends they deferred following the financial crisis, says Jason Zgliniec, a partner at Schiff Hardin.

The Small Business Lending Fund will also challenge its more than 130 participants. The SBLF's dividend rate is set to increase in 2015, Iannaccone says.

Increased regulatory scrutiny and persistently low interest rates are also contributing factors in deciding whether to sell, industry experts say.

"There are lower earnings, margin pressure and increased compliance costs," says Claudia Swhier, a partner at Barnes & Thornburg. "These decisions just aren't based on the increased dividend."

Hawthorn Bancshares (HWBK) has spoken to Tarp participants that were considering selling, says David Turner, the Jefferson City, Mo., company's chairman, president and chief executive. None have been the right fit, he says. The $1.2 billion-asset company recently redeemed the remaining $18.3 million of its $30.3 million in preferred stock and repurchased its warrants.

"I know there are banks … having those discussions and have had those discussions for some time," Turner says. "Most won't be able to repay Tarp."

The most troubled institutions are likely looking for an exit strategy, but M&A has been tepid this year. Industry experts say that deals will be hard to come by for banks stuck in Tarp, particularly as pricing remains a sticking point.

Offers for Tarp banks must factor in the cost of repurchasing the Tarp shares or paying the increased dividend, says Shaheen Dil, managing director of risk and compliance at the consulting firm Protiviti.

Pricing should be towards the "lower end of traditional bank M&A," Zgliniec says. Some potential sellers will reject such offers, especially now that there is hope that interest rates will start to rise, Mirchandani says.

Regulators are expected to favor deals where the buyer will repay Tarp funds. Buyers may seek a discount from the Treasury Department on repaying Tarp and any unpaid dividends, though that is far from a sure bet, Zgliniec says. Historically, Treasury has only approved a discounted repayment on deals that also included dilution to common shareholders, he says.

Banks looking to land deals may include those that were active in buying failed banks, Zgliniec says. Buyers must also be well capitalized and will generally be looking to grow significantly in a defined market, Mirchandani says.

Still, there is hope for some Tarp banks, industry experts say. Many banks are determined to stay independent and are looking to raise capital to exit Tarp. Swhier and Miller say they are working with Tarp participants on capital raises, adding that the response from investors has been positive.

Some of the healthier banks should be able to handle a higher dividend, industry experts say. A 9% rate is "expensive right now but if rates go up, it becomes less so," Turner says.

Many banks are viewing the dividend increase as just another expense, Miller says. "It's not crippling," he says. "Tarp won't push some banks into a deal. They are aware of the dividend increase and some have planned for it since day one."