Capital Markets and How Credit Unions Can Issue Subordinated Debt
Historically, credit unions have accessed capital through CDs, short- and long-term loans, and other investment funds to help them expand, generate income, and pursue strategic initiatives. However, as credit unions have grown over the years and offered more complex services, there is a demand to meet capital needs in creative ways. Loan participations and the secondary capital market are providing a new way for credit unions to manage their balance sheet.
Capital markets also create an additional opportunity for credit unions to become issuers of capital, particularly subordinated debt (sub-debt). In this episode, Doug welcomes guests representing Alloya Corporate Federal Credit Union, Bill Patton and Greg Hill. They discuss the forward-looking work they’re doing to improve loan participations, how a credit union can become a sub-debt issuer, and other factors credit unions should consider when entering the capital market space. Bill Patton is Alloya’s vice president of loan participation, lending in subordinated debt, and is responsible for the credit union’s overall corporate portfolio performance. Greg Hill is a strategic initiatives consultant, having had a key role in architecting and managing Alloya’s loan participation program. He is also a former credit union CEO and Alloya board member.
There are many reasons why credit unions may be interested in securing secondary capital, from increasing their net worth to pursuing an acquisition. However, Greg and Bill discuss how loan participations of the past have historically been clunky and arduous, causing Alloya to look into building a more efficient platform for credit unions to enter, secure, and issue capital. Their solution has created a more seamless, fully automated process that expands sub-debt buying opportunities so credit unions can buy smaller pieces of a larger loan.
Still, there is some hesitation among credit unions to become an issuer of sub-debt in the industry. The key reason is that credit unions must decide if they want to be an issuer or investor in sub-debt, a role they can’t reverse later. However, with net worth ratios dropping and bigger balance sheets, credit unions are unsure what the next five years will hold and may delay becoming an issuer if they may need capital in the future. For these reasons, Greg and Bill are working to educate boards and credit union leaders on the sub-debt issuing process and explain how credit unions can use the capital market as an opportunity to remain nimble in a shifting interest rate environment.
Listen to the full episode to learn more about why credit unions should consider getting pre-approved even if they choose not to issue sub-debt after all, and:
- What credit unions can expect from the process, which may take between one and three months or more from application to closing
- Why education is critical for credit unions to understand the long-term nature and implications of becoming either an investor or issuer
- How Bill and Greg are developing a first-of-its-kind secondary market for issuances so credit unions can have more flexibility in investing and issuing later
Stream the full episode and conversation now.
Bill Patton, Greg Hill, and Alloya Corporate Federal Credit Union are not affiliated with or endorsed by ACT Advisors, LLC.
Audio Transcription (pulled from the podcast)
My guests on today’s podcast are Bill Patton and Greg Hill from Alloya Corporate Federal Credit Union. Bill is the vice president of loan participations, lending, and subordinated debt, responsible for the overall performance of Alloya’s corporate loan portfolio. Greg is a strategic initiatives consultant who has worked on several key initiatives, including architecting and managing Alloya’s Loan Participation Program. He’s a former credit union CEO and was also previously an Alloya board member. In this episode, we talk about capital markets for credit unions, including subordinated debt, and what you can expect from the subordinated debt process as an issuer. Bill and Greg, thank you for joining me today. I know from our conversations in advance of this interview that Alloya is doing work in what I’ll call forward-looking areas. Can you tell me a little bit about some of that work?
Bill Paton (00:58)
I can lead into that. And I think I can paint a picture historically, what we had been in and what we’re trying to do. Looking back, corporates really have been from a capital markets perspective; what they’ve done is they’ve helped credit unions invest their funds through fixed income, securities, CDs, that kind of stuff. And they’ve provided short-term and in some cases, a little bit longer-term loans to the corporates, similar to what the FHLB system would do. And that’s primarily all they’ve done as it relates to capital markets. So, they’ve done those two things—they’ve done them very, very well. But as credit unions have grown, and they become more complex, more complex services are required for credit unions to meet those changing balance sheet needs. And so one of the things Alloya has done, whether purposely or just by chance—and I have to take a look back two or three years and try to figure out whether or not we did it purposely or not—but one of the things that we’ve done is we’ve really kind of gone in on the capital market space, understanding this is what credit unions are going to need. And so the first step in that direction was about seven years ago, we started helping credit unions trade loan participations, just through our inbox. A credit union would come to us, we had at the time, it was called part five authority, which allowed corporates to purchase loan participations from credit unions. And that was rescinded from us. And so we still had credit unions who would historically sell to us and we would buy and hold it on our balance sheet, but they still needed to get rid of those loans. And so what they did is they called us and said, hey, can you help us move these loans, just like a broker would. And so for about four years, that’s what we did. We just helped them. My supervisor at the time, Tim Bruculere, let me take this opportunity and run with it, which he didn’t need to do. I think in four years, we did like $1.5 or $2 billion worth of trades that nobody had even known about. We’re just kind of doing this on the side. And it kind of just became this big thing. And then our CEO, Todd Adams, said, hey, this is what credit unions need. And he challenged us. This is when Greg was brought in to create a platform for loan participations because the trading of loan participations at the time was very clunky; it was arduous. There were a lot of headaches. And so what we wanted to do is challenge ourselves to take all the headaches out of loan participations at least as much as we can. My tagline is, we’re the Tylenol of loan participations, we take away the headache of participations. And so that’s what we’ve done. Greg built the program with a couple of other people, specifically Ryan McCarroll, who’s vice president of loan participations. And I think, in 18 months, we’ve done about a billion dollars in trades, especially in a market where not a whole lot of trading activity was being done. What that platform does is it allows the efficient trading of these loans, the reporting, the due diligence, and it allows credit unions to buy smaller pieces of these pools and these loans. And historically, they would not sell. So historically, a $10 million deal would go from one credit union to another or maybe one to two other credit unions. Through our platform, you can go from one to twenty, one to thirty credit unions and it doesn’t matter. The only counterparty, I should say, is Alloya to both parties. So it’s really great. And that’s a really high-level overview. So that was kind of our first foray into that capital markets outside of what we’ve historically done. We brought on sub-debt and Greg and I are really tasked with going out and finding new things for Alloya to get into and we’re working on a variety of different things; whether any of those see the light of day we’ll find out. But we’ve really tasked ourselves, and Alloya has tasked us, with going out and finding things that credit unions need to be really there and at the forefront of credit union capital markets. So I talked a whole bunch, Greg, what did I miss?
Greg Hill (05:13)
I don’t think you missed a lot there. You know, that loan participation platform is the one thing I’ll say about that just as a little bit of a pitch; it’s fully automated. So it really does eliminate all of the headaches that credit unions have on the issuer or the seller side. And on the buyer side, sellers don’t have to do all of the monthly work that they’re doing now. With all of these direct participations that they’re doing, they literally can upload a single data file regardless of the number of pools they have. And that’s it, they can wash their hands a bit. Alloya takes care of all the reporting, all the funds transfer, everything else. And even on the sales side, it’s a very simple process. It’s a single file, upload it to make it really simple. The buyers love it. We provide full reporting for them, including a Call Report, which they absolutely love, that provides everything they need for themselves, regardless of the number of pools they purchased, regardless of the size and the number of originators. So it fully automates every aspect of their lives, including a standard Participation Agreement, which was a really big deal to get completed. We worked with I don’t know how many credit unions to get to a final agreement on that. But we now have, I think over 300 or 400 credit unions signed up with the platform, 30 or so plus sellers, 100 or so plus buyers, like Bill said, over a billion now of transactions since we went live with it.
You guys are making a difference in the credit union movement. Another solution, you provided credit unions deals with subordinated debt. I know you’ve partnered with two of our past guests, Jeff Cardone and Luse Gorman, to offer a full-service solution to credit unions looking to either invest or issue sub-debt. Now I know of course issuing credit unions have competition with other investments, mortgage-backed securities, other things. So how do you get investors interested in taking on sub-debt?
Bill Paton (07:05)
If you have a comparable investment, that is, let us say it’s an MBS or something of that nature, that’s a comparable weighted average life. An issuing credit union is going to have to compete with that, and so they will have to go above that level to get investors intrigued. So there are different things issuers can do to structure the security a little bit differently. We are seeing fixed to floating type structures, which is interesting, right? So rather than just a straight fixed rate for the 10-year term, fixed for the first five years, floating for the last five. And so we think that might be enticing to credit union investors. We’re also talking to investors outside of the industry who are keenly interested in this. They had been purchasing bank subordinated debt hand over fist over the last five or six years, and they’ve engaged with Alloya, and I’m sure other entities to start potentially buying that. So there’s interest. And I think as these become more commonplace, credit unions specifically will be interested in investing in these because again, at its core, it’s a loan to another credit union. There are a lot of reasons to like that investment. There are political reasons, there are philosophical reasons. But monetarily, it’s also just going to provide a greater yield compared to the comparable investments. So I hope that answered your question.
It did. So let’s talk about the ability to change from one to the other; you got to choose, right? You can either be an issuer or you can be an investor. So what’s the market for the ability to go from one to the other?
Greg Hill (08:47)
Yeah, I can talk about that a little bit. We think that’s been one of the key issues for potential investor credit unions, why they’ve been a little bit hesitant as well, because they’ve seen what’s happened in the last couple of years with balance sheets exploding and net worth ratios dropping. And so even some of those credit unions that have relatively high net worth ratios that are not considering issuing now just have no need for it. Now, we feel like some of them are just looking to keep their powder dry, because they don’t know what’s going to happen in two or three years, or four or five years. So if they invested today, they would not be able to issue in the future unless they were able to sell that investment. And that’s one of the things we’re trying to do at Alloya and with our Alloya Solutions, LLC partnership—to actually build a secondary market potentially over time with these credit union issuances. And so other potential credit unions, if they do invest, and at some point do need to issue down the road, there would be a market for somebody else to purchase that off their hands. Now obviously, that’ll come with a price, right? Depending on where interest rates are at, depending on where the issuing credit union’s financials are at that point in time to determine how much risk someone’s willing to take on, but we think that’s one of the things holding back a few credit unions from potentially investing is just they want to have that ability to wait and see if they need to issue. And so we believe we can create a little bit more of a secondary market or at least know there are credit unions that are looking for this investment on the secondary market; we’ll be able to get a few more credit unions up and going because that’s actually been one of the struggles we’ve seen is just credit unions are holding off a little bit. As Bill said, they’re a little nervous to get started investing in this. Although if you go look at some of the data, I think there are over 100 credit unions right now in the country that actually have investments in secondary capital. And some of the new subordinated debt, a lot of them are older investments that were made in secondary capital. But that still counts from the regulation. So those creditors would not be able to issue. So there’s going to be more that will consider this that just won’t have a need to potentially issue. And we’ll start to get into the investment side of things. But we do believe that NCUA did want to bring in funds from outside of the industry with some of these. And we certainly saw that with one of the larger issuances that just came out. And I won’t mention the name, but a credit union just issued a couple of 100 million dollar subordinated debt—it was the first one in the marketplace that happened. And that one did get a fair number of credit unions. But there were also many other investors that came into that from some insurance companies and banks and others, and other asset managers that came in with the investment. We are going to see investment from a lot of different places. And it’s really just at this point getting the word out to those other investors that this is out there. And then it looks like a good investment.
But is there no capital markets option for credit unions at this time? Is Alloya the innovator in that space?
Greg Hill (11:33)
We’re trying to be that right now, there isn’t any other type of capital markets group working specifically to create a secondary market for this. We’ve spoken with several other of the potential issuers and broker-dealers that are in the space helping credit unions. And I think you’ll start to see a little bit of cooperation there within this group of potential investment banks and others to try to make sure that we can provide a secondary market for this; you’ll start to see a little bit more of these deals. On the credit union side, we anticipated that most of them would not get rated; they’re going to be smaller deals that would be unrated. Like some of the smaller bank deals, but some of these larger ones have been getting ratings, you’ll see CUSIPS for all of these deals, so at least if somebody does need to there will be the potential for a secondary market for this. And that’s something we would like to help build over time with our credit union partners.
Yeah. Well, I like what Bill said about the five-year fixed rate and then five-year floating rate. That way, if you’re in an interest rate environment that’s going up, as we all appear to be, that would take at least some of the interest rate risk off the table.
Greg Hill (12:38)
Yeah, interestingly enough, it was banks that pretty much primarily have been issuing with that structure—10-year terms, five-year note calls with fixed flow rates fixed for the five and floating in the last five—whereas the credit unions we’ve seen have almost exclusively issued fixed-rate notes, 10-year fixed rates, which is pretty typical, from credit union’s perspective; they don’t want that additional trade risk from the issuer side. But as rates move a little bit, investors get a little bit nervous with those types of structures. And so we are actually the first deal that we’re going to be placing out very shortly and we’ll have a fixed to floating rate structure, which we think will be the first one from a credit union’s perspective on the new subordinated debt rule.
Let’s take a step back and talk about the debt issuance process. Now listeners can check out our past episode with Jeff Cardone for an attorney’s perspective on the legal structures of the process. Now, I’d like to talk about the process once the capital has been issued. For instance, if a credit union wants to issue $10 million, tell us about the flow of funds from issuance all the way to where the deposit is back on your balance sheet, and then its lifecycle over the next 10 years.
Greg Hill (13:51)
I can start off with that a little bit. So, what is the issuance once the credit unit makes that determination to actually issue the debt? That’s where Alloya steps in and we’re actually working with Jeff Cardone and Luse Gorman and another partner to help build and simplify it for credit unions to actually get it issued. The simple process is they discuss it, they get through the application requirements with NCUA and their state regulators get approval. At that point, Alloya and the legal team step in to build offering documents to find investors; that’s proving to be a little bit more of a difficult aspect of it. One thing to keep in mind with credit unions is now credit unions can do this on their own. In theory, the regulation allows them to actually sell these notes if they had someone—a friends and family type credit union down the road that was willing to purchase subordinated debt from them—they can actually do it themselves. But the regulation does require if they don’t do it themselves that it goes through a registered broker-dealer. It’s a little different than the secondary capital regulation that didn’t have that type of requirement. Once that happens, that’s where our broker-dealer steps in, our Alloya Solutions investment representatives go out and start giving an offering document and any type of marketing materials to potential investors. Once we get indications of interest back in with amounts that investors want to purchase, potential interest rates they would be willing to accept—whether that’s the initial fixed-rate or if it’s a fixed-rate deal overall, what rate they’d be willing to accept—at that point we work with our issuer to say, this is the indications we have, here’s where we need to place this at what rate for everybody that we can get a full subscription to it. At that point, once that agreement is set and we have terms set, the settlement process is relatively simple. We build a note, a physical note, in a purchase agreement; we get those pushed out to credit unions on the investment side to sign as well as our issuer. As they start to build, one of the things that’ll change with that and one of the things with the larger deals that you’ll start to see, is it’ll act a little bit more like a standard private placement from the industry perspective where they will be DTC eligible. So that’s a global note consideration as opposed to physical notes. And that’ll depend on the type of investor. We do not anticipate that we’ll be putting these out to individually accredited investors, which is allowed within the regulation; we think they’ll all be entity accredited investors or qualified institutional buyers. So that’s where depending on the size of these, you might just see some with physical notes, and some that will go into with CUSIPS into the global DTC note aspect of things. But once that’s done, funds are transferred to Alloya—that’s what we do, we are a payments company, a transaction organization. And so we handle those payments between buyers, investors, and the issuer; money changes hands at that point, it’s complete. So the money comes in from those investors either through us potentially down the road with larger deals, again, that could be handled through a separate settlement agent, depending on the type of investors, but issuer receives the funds they drop on their balance sheet counting toward their capital; they’ve got the cash, they can, at that point, do whatever they like with it. From there on, they’ll start making their interest payments. Typically, you’re going to see these are going to be quarterly or semiannual interest payments. We’ve seen a little bit of both; it just depends on the issuer and what their preferences are, what investors are looking for. Alloya can actually handle that as well as a paying agent, depending on the credit union and who the investors are for them because we do hold their accounts at Alloya. So that makes that process fairly simple. At that point, then it’s just servicing it, right? It’s annually providing potentially annual reports to those investors, those types of things, making your interest payments until you get to years five through 10, when the rate may adjust. The other aspect of that we didn’t talk about is the prepayment component of it. So these are potentially callable. NCUA, what they did with the regulation. And this is the same with the bank side of things in the balances you own. So say you did a $10 million issuance; after five years, in those last five years, it reduces by 20% per year—how much counts toward your net worth ratio? So if you issued $10 million, beginning in year six, only eight million counts, and then six million, four, two, and zero as you get to year 10. And so NCUA does allow those issuers to prepay those amounts at that point in time. With their pre-approval, you have to request approval each year to do that. But you’ll see the structure of all of these that in the notes and purchase agreement will have that potential prepayment call ability available. And that’s pretty much it. That’s the process and the flow, relatively simple once you can find investors and get ready to go.
Absolutely perfect. That’s exactly what I was looking for Greg. Did you have anything to add to that Bill?
Bill Paton (18:21)
No, that was flawless.
It was a work of art, absolutely. Perfect to really understand how the entire process gets done. I’m going to ask you two questions. So, Jeff had said he was seeing a lot of credit unions get pre-approved to be able to issue. Any comments you have about the pre-approval process? And then the second is, if you haven’t gone through pre-approval, how long is it from pre-approval all the way to issuance compared to if you’ve got the pre-approval, then what is your time to issuance? Or is there a further step down the ladder you should take before you pause? Because really you truly engage once you go to issue. So how far should you go in advance of that to be ready to be nimble?
Bill Paton (19:08)
Sure, I’ll take the first step. So, in terms of the pre-approval, and I know Jeff is a fan of that, and I think most people are a fan of that, there are really two steps to this process. There’s getting approved, and then there’s issuing of the funds. And so the approval aspect of it, once you’re approved, you get two years to go forward and issue bonds. That’s the crux of the regulation. The reason why you would want to get pre-approved is to remain nimble dependent upon what interest rates happen. So as an issuer, flexibility is your key. In a rising rate environment, you want to issue as quickly as humanly possible to save yourself on the interest expense. But I don’t know—is it always going to be a rising rate environment? I mean, if you talk to certain people, they’ll say, hey, yeah, the Fed’s going to raise rates nine times in the next two years. Or maybe you think the Fed is raising rates just to cut it in the next six months. And they’ve been proven to do that.
Is that what’s going to happen? Bill, is that economic forecast? I need that, let’s hear it.
Bill Paton (20:11)
I am not an economist, although I would argue that economists are about as useful as weathermen. So I don’t think anybody can read the future. And if we could, we certainly wouldn’t be working with credit unions. So all that being said, if you go and get pre-approved, you can use the environment to your advantage. So that’s kind of the process and the process of being pre-approved can take anywhere from one to three months, depending upon how far along you are. And really what that is, it’s the building of the business plan and the application to go to the NCUA. It’s coming up with a narrative around why you need funds but most importantly, how you’re going to repay those funds. And it’s the pro formas along with that, what you’re going to do with the funds, and as I said, the most important thing is how you’re going to pay those back. So some credit unions have that kind of business plan already built. And it’s really just getting it into an application and then getting it to the NCUA. There are some conversations, you want to kind of get the NCUA on notice, let them know that this is coming. But that could take a month if you’re on top of it. Generally speaking, most credit unions are going to take two to three months to get approved. You have to get the board approval, there’s some board acknowledgment that you have to get.
So let me stop you, Bill. That was going to be my next question. Is there some educational material Alloya has created for a CEO to work with their board?
Bill Paton (21:43)
Sure, we have a microsite, alloyacorp.org/subordinated-debt. And anybody, anytime, can go out there and do that. One thing I will say is every application and every issuance is unique. And therefore, if you are interested, come and talk to us, come and talk to anybody. And we’ll actually work with our partners to get your board educated on this whole process. That’s part one. So while we do have some canned stuff, we have webinars out there—I think I’ve done two of them—you can go and listen to them at any given time. You can listen to the “CU on the Show” podcast at any given time, a little shameless plug. Ultimately, we want to cater to you and your credit union. I know Greg has given a couple of things individually to credit unions. So that’s what we want to do further. So that’s one to three months, right, you got to get the board educated, you got to get the application good with the pro formas you get in, you put it in for approval. From there, you generally wait 60 days or longer for the NCUA, because the NCUA gives itself 60 days to come back with approval, denial, or request for an extension. And one of the interesting things we found out is they can just grant themselves additional time should they need it, which is really interesting. So I would tend to say 60-plus days right now is probably going to be the expected timeframe for approval on that. And then once approved, you get the documents ready, like Greg said, that can take a week or two. And all on this timeframe, we’re sitting there talking with the credit union, discussing strategy on how to get the market, talking with investors, what are you seeing what would be interesting to you, things of that nature, we’re trying to do that on the back end, of course, without knowing whether or not this will be approved or not. But we’re just trying to get some market color, or once the documentation is ready, marketing material goes out to the investors. And so the one key to the closing process is that every purchase must be approved by the board of the investing credit union. And there’s no way around that. So at a bare minimum, it’s going to take a month to six weeks—every deal from the moment it hits the market to closing, which is different from a secondary capital.
All right, guys, this has been absolutely outstanding information. So a summary statement, any final thoughts for our listeners for the movement about what they need to be watching in the capital markets activity and the sub-debt market, and any other final thoughts?
Greg Hill (24:32)
From the subordinated debt aspect of things, credit unions should just get educated on it and understand what it does for them. The one thing we tried to do with most of the credit unions we talked to makes sure they really understand the long-term nature of this product. If they move forward with this, they can’t get out of it. It’s not something they can do this year and in two years say we don’t want this anymore, we’re just going to pay it off. It doesn’t work that way.
Especially until you get the capital markets live, right? That’s a pretty significant commitment.
Greg Hill (25:03)
Right. But even that, from the issuer’s perspective, it’s there for 10 years, the term they can’t get away from. So it is a long-term decision that may span management teams and boards of directors. And so we just want to make sure the credit unions are very educated about that and don’t move into something that really maybe isn’t something they really need to do at this point. And that brings up that point where maybe getting pre-approval is not a bad thing. If you want to consider this, start down the path of getting the approval; you have two years before you actually have to issue. So if you get approved, you can wait, you can sit back and hold off and not issue and take a little bit more time. And so that’s one thing we have recommended credit unions consider doing, depending on their strategies, whether they’re looking at mergers, acquisitions, bank acquisitions, things like that, for them to consider. But that’s probably the biggest issue. Other than that, from the issuer’s perspective, as long as you’re knowledgeable about what’s going on, and you understand what the long-term ramifications are and the financial concerns might be from paying it back, your actual cost of issuance, it’s definitely something that everybody should be aware of—how it could work for them—and potentially start incorporating those into their business plans today. It’s something they will consider maybe in the future, whether that’s six months or two years from now. But we’re happy to talk to any credit unions; we’ve talked to hundreds probably at this point.
Bill Paton (26:17)
Change is coming and change is good. We’re changing, credit unions are growing, credit unions are evolving. And that’s not necessarily a bad thing. So we look forward to working with credit unions on all things capital markets related.
Well, thank you guys, thank you for your service to the credit union movement and for your great content on “CU on theShow.” I look forward to when you tell me, hey, I’ve got this new thing that’s happening that the movement needs to know about and we’ll get you back out again. Have a great rest of your day.
Bill Paton (26:55)
Thanks, Doug. Great talking to you.
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