Hedge Fund EJF Makes CDO Bets To Profit From Bank Mergers

(Bloomberg) -- Smaller U.S. banks are increasingly merging, and hedge fund EJF Capital is looking at ramping up its bets on an unusual type of collateralized debt obligation that can profit from that consolidation.  

EJF buys pre-crisis collateralized debt obligations backed by a kind of bank debt known as trust preferreds, a hybrid of bonds and preferred shares. The fund then breaks open the CDOs and repackages the trust preferreds into new securities. 

When one bank acquires another, it may pay off the trust preferreds of its target, giving extra cash flow to the CDO. And the acquiring bank is usually stronger than the lender being bought, boosting the credit quality of its trust preferreds and potentially helping spur a ratings upgrade for the CDO.

With mergers boosting the potential profits on the securities, EJF has been looking at doing more repackaging next year. The firm typically completes an average of two of these transactions per year but may try to do three or more next year. It last priced a $175.9 million transaction nearly a year ago.  

“Given the strong tailwinds in the sector, the favorable macro environment for banks and market dynamics, we believe we could see a lot more activity going forward in the asset class,” Omer Ijaz, senior managing director of portfolio management at EJF, said in an interview. 

Bank M&A has been active this year: there have been more than $39 billion of acquisitions announced or completed this year in the U.S., according to data compiled by Bloomberg, putting this year on track to be the second busiest in the last decade for these transactions.  

That pickup comes after a drop during the pandemic: in the years following the financial crisis, there were an average of 200 to 275 mergers of community banks annually, according to EJF. In 2020, that number dropped down to about 125. 

EJF has issued nearly $4 billion of CDOs backed by legacy TruPS and other subordinated debt since 2016 across 12 different securitizations, or historically between $600 million to $1 billion of issuance a year. It usually holds the equity in the resecuritized deal.

Arlington, Virginia-based EJF had assets under management of $5.7 billion as of Sept. 30. Another major player in the TruPS CDO market is Hildene Capital Management.

Legacy Deals

TruPS are essentially a type of debt that to regulators had equity-like characteristics. Before the 2008 financial crisis, the securities offered benefits of both bonds and stocks for companies including banks and insurers: the interest payments are tax-deductible as with debt, while the securities could partially count toward regulatory requirements for equity capital. 

Post-crisis financial law changes have eliminated the equity-like treatment for TruPS for all new securities for many banks. 

CDOs backed by TruPS suffered during the 2008 U.S. mortgage meltdown after banks tried to preserve cash by halting or delaying payments on their trust preferred obligations. Prices on the CDOs plunged.

Those securities have been recovering in recent years, in part because they pay floating rates and investors expect the Federal Reserve to eventually lift rates. And with bank profits having risen over the last few years, default and deferral rates on the trust preferreds backing the CDOs are dropping. 

Moreover, the 2010 Dodd Frank Act stripped trust-preferred securities of their Tier One regulatory capital treatment for banks with more than $15 billion in total assets, giving larger banks motivation to pay off their TruPS early, which will help the performance of the TruPS CDOs that contain them, Ijaz said.

Legacy trust-preferreds trade at a discount to par, Ijaz noted, but if a larger bank acquires a smaller one and pays off its TruPS debt, it may prepay at par, which is a positive sign for credit quality and return possibilities.

“There’s a potent atmosphere for M&A activity, depending on your views of growth of the U.S. economy,” Ijaz said. “One very strong way for community banks to make money is to make accretive acquisitions.”

Relative Value: CMBS 

• After another month of CMBS outperformance, some reversion with IG corporate credit performance is likely, Deutsche Bank analysts said in a research note this week
• AAA CMBS and single A corporates rarely diverge significantly for prolonged periods
• DB analysts still like adding longer duration single As, “but there isn’t much yield in CMBS outside BBB- bonds, after decline in Treasury yields,” they wrote

Quotable

On why it may take longer for CLOs fully priced off of SOFR to appear: “The market wants to demonstrate it can do SOFR CLOs as a ‘proof of concept’” first, said Meredith Coffey, executive vice president of research and co-head of public policy at the Loan Syndications and Trading Association

What’s Next

ABS deals in the queue include Foundation Finance (home improvement ABS), Atalaya (large-ticket equipment ABS), Honda (prime auto), and Conn’s (consumer loan)

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