Analyst: Be Careful What You Wish for on Alternative Capital

Michael Bartlett
September 8, 2009 | COMMENTS

While many in the credit union movement see alternative capital as a positive, one analyst says be careful what you wish for.

Richard Garabedian, partner in Washington-based law firm Luse, Gorman, Pomerenk & Schick, said giving credit unions the ability to raise alternative capital simply means they have the option to weigh if the issuance and compliance burdens are worth it.

"It is a balancing question," he assessed. "Most discussions seem to focus on, 'Isn't this a great idea for credit unions?' But drilling down, there is more to it."

Garabedian said the basic premise is federal legislation would authorize alternative or secondary capital for credit unions, and federal tax law would be amended to ensure tax exempt status is retained. "There have been attempts in the past to make alternative capital available to credit unions, but first there must be a change in the law," he said.

During a recent educational session, Garabedian took a brief survey of the room: roughly half of attendees believed alternative capital for credit unions is a good idea.

He then asked for someone to define the acronym FDIC. When one man replied "Federal Deposit Insurance Corporation," Garabedian corrected him: "No, it stands for Forever Demanding Increased Capital," adding the Obama administration is pushing for higher capital levels.

Three Types of Alternative Capital

There are three types of alternative capital, Garabedian explained: subordinated debt, preferred stock, and pledged deposits. He said subordinated debt works the same way as equity and is, as the name implies, last in line behind all other obligations of the issuer. The cost for subordinated debt is higher than other types of borrowings because it is unsecured and subordinated, and it requires a minimum of five years before maturity.

"Market conditions for subordinated debt are improving somewhat, but they are nothing like what they were four or five years ago," he said.

Preferred stock first would require the creation of a subsidiary or a CUSO to issue it to investors, Garabedian continued. He said the proceeds would be invested in the credit union as capital in the form of subordinated debt or a pledged deposit, and terms would be similar to subordinated debt.

A pledged deposit is similar to paid-in capital with corporate credit unions, said Garabedian. It is uninsured with no stated maturity and cannot serve as collateral.

"Unless it is exempted by federal or state securities laws, alternative capital would be considered a security," he cautioned. "Credit unions would have to comply with securities laws or seek an exemption."

Where Would It Come From?

Potential investors in alternative capital for credit unions would include other credit unions, members, institutional investors, and the general public. Garabedian said the first option means risk would not be transferred out of the credit union system. If members were to invest, he worries about a potential lack of sophistication and the possibility of confusion with insured deposits — as happened with Charles Keating's Lincoln Savings in the mid-1980s.

For any of these options, "If credit unions are going to issue alternative capital, there are burdens that must be met," Garabedian advised. These include creation of offering documents, releasing periodic financial information that is much more detailed than a 5300 Report, operational restrictions that might mean maintaining certain capital ratios, and the possibility of investors gaining board seats if payments are not made.

"The issuance and compliance process is not insignificant, and additional burdens must be addressed," he warned.

Asked the probability of having the option, Garabedian said the chance is "less than 50-50. It is an uphill battle. The bankers will fight it and may demand a quid pro quo, such as credit unions paying some taxes in exchange to access to alternative capital."

This article appeared at www.cujournal.com and is reprinted with permission.