MReport July 2019

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32 | TH E M R EP O RT O R I G I NAT I O N S E R V I C I N G DATA G O V E R N M E N T S E C O N DA R Y M A R K E T THE LATEST ORIGINATION Advantage, Community Banks Why is it beneficial for big lenders to consider community banks in their acquisition strategy? By Cheryl Pate T he Great Recession, although now fad- ing into history, was certainly devastating to financial markets in general and banking institutions specifically. However, the strategic response to the crisis by financial institutions, coupled with legislative initia- tives that drastically altered the regulatory landscape, has resulted in a fundamental reboot of the banking industry. Balance sheets have largely been scrubbed of troubled assets, capital and loan loss reserves are at all-time highs, and earnings are approaching pre-crisis levels. There are many environmental factors at work that point to continued strong performance from banking insti- tutions across the board. While regulatory changes en- acted in the Dodd-Frank Act have improved the overall health of the banking sector, the Dodd-Frank Act also forced banks to change their capital structure, bringing an abrupt halt to the $60 bil- lion Trust Preferred Securities ("TruPS") market. Post-financial crisis, large banks have had easier access to the capital markets, yet it has been more challenging for smaller banks to raise or replace capital, whether in the public or private markets, as poten- tial investors are more scarce. Thus, community bank sub-debt issuance is on the rise due to renewed interest from investors after a long drought. The current market inefficiency leads to a unique opportunity for sophisti- cated investors who can identify relative value in the space. At the same time, larger banks continue to acquire smaller banks in order to achieve the much-needed scale required to survive in the new utility model of banking that regulators are encouraging—and mandating. As the Federal Reserve moves to a neutral stance and with earnings growth likely at cyclical highs, mergers and acquisitions (M&A) will continue to accelerate. We are seeing evidence of this as M&A activity has continued despite recent stock market volatility. Additionally, industry consoli- dation generally has had a very favorable impact on the value of bank debt, especially those securi- ties issued by smaller institutions, which tend to be acquired by larger and stronger banks. In most merger/acquisition scenarios, the acquirer assumes the liabilities and continues to service any out- standing debt of the acquired in- stitution. The outcome is often an upgrade in the overall perceived credit quality of the acquired debt, leading to substantial price appreciation. Community bank sub-debt should provide stable performance with low volatility considering the banking sector's strong capital bases and credit quality underpinned by solid economic fundamentals. In addition, the rising issuance of bank sub-debt, particularly by smaller banks, presents a compelling opportunity to find relative value. Cheryl Pate is a Senior Portfolio Analyst at Angel Oak Capital. Pate has more than 15 years' experience in financial services and primarily focuses on investment research, particularly in the nonbank financials and community banking sectors. Pate joined Angel Oak in 2017 from Morgan Stanley, where she was an Executive Director and Head of Consumer & Specialty Finance Equity Research. Her re- search coverage included the con- sumer finance, specialty finance, mortgage servicing/originations, mortgage REIT, payments, fintech, and banking industries. Pate holds an M.B.A. from Duke University's Fuqua School of Business and a B.S. in Commerce (Finance) from the University of British Columbia. She also holds the Chartered Financial Analyst (CFA) designa- tion.

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