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EJF Capital markets $258M CDO of bank subordinated debt

EJF Capital is launching its seventh securitization of subordinated bank debt, via a CDO vehicle that allows smaller banks to raise capital more cheaply and efficiently for regulatory purposes.

The $258.8 million transaction dubbed Financial Institution Note Securitization 2019-1 is a collateralized debt obligation backed by a portfolio of $250.45 million bank-issued bonds, consisting mostly of subordinated debt obligations. The assets are EJF’s partial interests in 47 notes issued by 45 banks, which pay quarterly principal and interest payments to institutional investors lined up by EFJ.

EJF Capital is among a small club of private-equity firms helping smaller banks tap the securitization market to address capital needs, particularly for shoring up Tier 2 (or supplemental) capital ratios.

By selling subordinated debt bonds into structured-credit pools, banks can raise funds at lower rates than they would by selling the bonds themselves directly to institutional investors.

The rates are lower since the community banks are piggybacking on the higher investment-grade credit rating achieved through the CDO structure that limits exposure to any single institution.

The capital stack of the CDO features a $180.2 million in Class A notes with a preliminary Aa2 by Moody’s Investors Service (one notch below a top triple-A rating), and a $27.6 million Class B tranche of notes with a Baa3 rating. A Moody’s presale report indicated the issuer expects to market the Class A notes at 4% and the Class B notes at 5.4%.

The deal requires that the balance of the underlying debt be maintained at a minimum cushion above the outstanding note balance held by investors. The deal is being issued with a 138.98% overcollateralization for the senior Class A notes and 120.52% for the Class B notes. If the cushion falls below 126.98% for the A note or 112.52% for the B notes, cash flows that normally would be collected by EJF as the preferred shareholders would be diverted to investors until the minimum gap is reinstated.

The notes will receive quarterly principal and interest payments over the life of the deal.

The subordinated debt in the portfolio has a 10-year legal maturity – much shorter than the terms of pre-crisis trust preferred securities, or TruPS, that banks issued to raise capital in the pre-crisis era. TruPS, a hybrid debt-equity security, fell out of favor in after their high default rate performance during and after the financial crisis. They also no longer qualify as regulatory capital.

But the deal is callable after five years, which is typically when subordinated debt bonds are expected to be paid off.

Banks and issuers are incentivized to call deals that soon since interest rates on the notes begin stepping up annually in year six, and the Tier 2 capital treatment of the securities becomes increasingly diluted for banks in the latter five years of a deal’s structure.

The noncall period ends July 2021, and the reinvestment period for EJF to buy and sell assets in the portfolio expires in October 2021.

The debt was purchased from undisclosed financial institutions from all regions of the country, and include a “number” of bank holding companies who already hold “significant amounts of other debt of their balance sheet” – a potential added risk factor for investors that Moody’s factored into its deal performance assumptions.

Arlington, Va.-based EJF Capital’s CDO team manages 10 other pre-2007 and post-2007 bank and insurance TruPS CDOs. EJF Capital manages approximately $7.5 billion of assets across its various alternative asset management vehicles.

Bank of America is the underwriter.

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