WO2008036340A2

WO2008036340A2 - Financial institution leveraging and organization process

Info

Publication number: WO2008036340A2
Application number: PCT/US2007/020348
Authority: WO
Inventors: Dennis Kert Moore
Original assignee: Town North Bank, N.A.
Priority date: 2006-09-20
Filing date: 2007-09-20
Publication date: 2008-03-27
Also published as: WO2008036340A3

Abstract

An system for and method of investing capital is presented. The system and method improve upon prior art techniques by increasing the investment's net interest income and net interest margin. The invention is particularly suited for financial institution investors, such as banks, credit unions, and savings institutions.

Description

FINANCIAL INSTITUTION LEVERAGING AND ORGANIZATION PROCESS

RELATED APPLICATION

[0001] The present application claims priority to, and incorporates by reference in its entirety, U.S. Provisional Application No. 60/826,326 to Moore et al. filed September 20,

2006 and entitled "Financial Institution Leveraging and Organization Process."

BACKGROUND OF THE INVENTION

[0002] Financial institutions such as banks, credit unions and savings institutions generally obtain income by investing in instruments such as loans, overnight investments

(e.g., Federal funds), and government and municipal securities. Smaller financial institutions, such as community banks with assets totaling under one billion dollars, are increasingly looking for ways to increase their net interest margin (i.e., the difference between interest earned and the associated interest expense on deposits and other borrowed money). In addition, such financial institutions generally wish to increase their return on equity.

BRIEF DESCRIPTION OF THE FIGURES

[0003] Fig. 1 is a flowchart illustrating an embodiment of the invention.

DETAILED DESCRIPTION OF PREFERRED EMBODIMENTS

[0004] The following description is intended to convey an understanding of the present invention by providing specific embodiments and details. It is understood, however, that the present invention is not limited to these specific embodiments and details, which are exemplary only. It is further understood that one possessing ordinary skill in the art, in light of known systems and methods, would appreciate the use of the invention for its intended purposes and benefits in any number of alternative embodiments, depending upon specific design and other needs.

[0005] Certain embodiments of the invention include a method of investing capital.

Such embodiments provide financial institution investors, such as banks, credit unions and savings institutions, with improved net interest income and net interest margin compared to prior art techniques. In general, certain embodiments provide a technique for leveraging investments in instruments such as mortgage backed securities. Certain embodiments form and utilize two companies - a management company and an investment company - in order to effect the technique. The companies employ portfolio management strategies in executing a leveraged investment program. As discussed in detail below, certain embodiments allow investors, such as financial institutions, to enter into equity investments in one or both companies. Certain embodiments allow investors to avoid equity accounting of the investments in favor of cost accounting. Further, certain embodiments allow investors, such as financial institutions, to avoid financial statement consolidation of their investments.

[0006] Fig. 1 is a flow chart illustrating an embodiment of the invention. According to this embodiment and by way of non-limiting example, at step 105 a financial institution (the "sponsor financial institution"), such as a bank, a credit union, or a savings institution initiates the process by establishing a management company. The management company may be a limited liability company, a partnership, a limited partnership, a corporation, or any other type of company. Establishing the management company may occur by filing papers with an appropriate authority, such as a secretary of state, or may occur informally, such as by merely drafting papers that announce the existence of the management company. The management company may employ a staff of individuals skilled in the art of investment management. As explained in detail below, the management company will provide financial advice, management and services to a second company, which is called the "investment company."

[0007] The sponsor financial institution may provide infrastructure and administrative support for the management company, including, by way of non-limiting example: human resource services, data processing services, sales and marketing support services, and general and administrative services. The management company may reimburse the sponsor financial institution, by way of non-limiting example, at a rate of 10% of the management company's pretax income.

[0008] At step 110, the management company is capitalized. As part of this step, the sponsor financial institution purchases shares in the management company. This may be followed by, or may be simultaneous with, other investors, such as financial institutions, purchasing shares in the management company. The management company may be capitalized by six or more total investors (including the sponsor financial institution) in such a way that each investor owns less than 20% of the management company. Certain benefits accrue under such an arrangement. In particular, it is expected that the investors will not have to consolidate the management company in their financial statements. In such embodiments, the investors benefit by avoiding regulatory requirements that specify limits on leveraged investments. [0009] At step 115, a second company (the "investment company") is established. Similar to step 105, the investment company may be established by filing papers or merely creating papers that document its existence. Further, the investment company may be a limited liability company, a partnership, a limited partnership, a corporation, or any other type of company. The sponsor financial institution, the management company, or another entity may establish the investment company. The investment company may not have any employees. As described below, the management company may manage the investment company's investment portfolio. That is, the management company may work with the investment company to carry out steps 125, 130 and 135. Formally, the investment company and the management company enter into a contractual agreement whereby the management company manages the investment company's investment portfolio in exchange for being paid a fee by the investment company.

[0010] At step 120, the investment company is capitalized. The management company may provide an initial capitalization by purchasing common stock (or, in some embodiments, other types of stock) in the investment company. The management company will thus own the investment company in its entirety, at least initially. The management company may invest all or substantially all of its capital in the investment company at this stage.

[0011] The investment company may then issue a private placement memorandum (by way of non-limiting example, a two-year subscription agreement) where other financial institutions can elect to purchase their choice of common, non-cumulative preferred, preferred, or any combination of these stock classes. The preferred stock may carry convertible features allowing the holders to convert to common stock of the investment company. In some embodiments, at least six investors (including the management company) hold shares in the investment company, where each investor owns less than 20% of the investment company. In some embodiments, the investors in the investment company will not have to consolidate the investment company in their financial statements. Such embodiment have the benefit of avoiding regulatory requirements that place limits on leveraged investments.

[0012] In some embodiments, the investors in the investment company account for their investments using the cost method of accounting, as opposed to the equity method of accounting. Such embodiments provide benefits to financial institution investors in that adjustments in market value of their investments may not require adjustments to their capital ratios. [0013] At step 125, the investment company uses all, or substantially all, of its capital to purchase securities, by way of non-limiting example, mortgage backed securities. In general, mortgage backed securities are commodities consisting of packages of mortgages. Favorable features of mortgage backed securities include liquidity, marketability, structured duration and, as described in relation to step 135 below, the ability to serve as collateral for financing. Other advantages of mortgage backed securities include: lack of credit losses, no manpower required for loan servicing, no marketing costs for loan origination and no costs associated with marketing.

[0014] Next, at step 135, the investment company leverages its investments. This step can be viewed as including several sub-steps. Thus, the investment company enters into a repurchase agreement with a financial institution such as a brokerage firm based on its mortgaged backed securities. Essentially, the agreement is a loan in which the investment company receives cash from the brokerage firm and uses its mortgage backed securities as collateral. During the pendency of the loan, the mortgage backed securities may be held by the brokerage firm or may be placed in a trust. The investment company then uses the loaned money to purchase additional mortgage backed securities. It may then use the additional mortgage backed securities as collateral for another loan (i.e., repurchase agreement). The investment company may repeat the sub-steps of purchasing mortgage backed securities and obtaining loans using the purchased securities as collateral many times. Thus, the investment company finances its purchases of mortgage backed securities using repurchase agreements.

[0015] In some embodiments, the investment company is limited on the number of times it may repeat the sub-step according to a leverage limit. For example, the investment company may be limited by being required to retain, in cash, 7% of the cumulative leveraged amount.

[0016] As part of step 130, the management company actively manages the investment company's investment portfolio. In particular, the management company may actively manage both the investments and funding of its balance sheet. Mortgage backed securities tend to have predictable payment behaviors relative to changing rate environments. Typically, interest spreads will narrow in a rising rate environment, thereby reducing return on investment, and widen in a falling rate environment, thereby increasing return on investment. These predictable behaviors afford the management company the opportunity to favorably structure funding towards maintaining an acceptable spread of interest income versus interest expense. In sum, different rate environments present opportunities to sell and replace existing investments. If payment behaviors of a mortgage backed security changes due to different rate environments, the repurchase agreement structures can be managed to protect net interest margins.

[0017] At step 135, the investment company pays dividends on its stock. Such dividends may be paid when the investment company earns returns on its leveraged investments. Note that when the investment company pays dividends on its shares, all shareholders receive such dividends, including the management company. That is, the management company receives dividends on the shares it owns in the investment company. The management company thus earns income in addition to the fees that it collects for managing the investment company's investments. The management company may pay out dividends to its shareholders based on its earnings. That is, the management company may pay dividends on its shares to each entity, generally including the sponsor financial institution, that owns its shares. Embodiments in which the management company is structured as limited liability company allow for pass through taxation for the investors on received dividends.

[0018] Note that, in contrast to Real Estate Investment Trusts ("REIT"), which require that a high percentage {e.g., 95%) of a REIT's earnings be immediately paid out in the form of dividends, certain embodiments of the present invention allow the investment company to retain its earnings without any required dividend payout. This is beneficial in that it allows the investment company to hold significant cash reserves. [0019] In some embodiments, investors, such as financial institutions, convey a portion of their investment portfolio to the investment company for the investment company to manage. The investors retain ownership in their portfolio, but the investment company actively manages the investment on the investors' behalf. In such embodiments, the management company may charge a fee for such a service. By way of non-limiting example, the management company may charge nothing for the first six months and at 4.5 basis points on assets thereafter. Further, the investment company may implement restrictive cancellation penalties and disincentives for termination without cause. [0020] In some embodiments of the present invention, the management company and the investment company are structured so as to be subject to the requirements of Financial Accounting Standard ("FAS") No. 115 or other specified Generally Accepted Accounting Principles ("GAAP") literature, as opposed to provisions of the Audit and Accounting Guide "Audits of Investment Companies." In such embodiments, mark to market fluctuations in the investment company's portfolio will generally be recorded as Other Comprehensive Income ("OCI") in stockholders' equity, as opposed to being recorded through their income statements.

[00211 The following discussion, presented in view of pronouncements by Financial Standards Accounting Board ("FASB") and the American Institute of Certified Public Accountants ("AICPA"), explains how certain embodiments enable investors (including the sponsor financial institution) in the investment company or the management company to avoid consolidation. Relevant accounting standards and reporting principles for consolidated financial statements, combined financial statements, and comparative financial statements include the following: Accounting Research Bulletin ("ARB") No. 43 (Chapter I(A), Rules Adopted by Membership and Chapter 2(A), Comparative Financial Statements), ARB-51 (Consolidated Financial Statements (as amended)), FAS- 94 (Consolidation of All-Majority-Owned Subsidiaries), FASB Interpretation Number ("FIN") 46(R) (Consolidation of Variable Interest Entities), and Emerging Issues Task Force ("EITF") Issues.

[0022] Other than equity ownership, some embodiments include no other variable interests (as defined in FIN 46(R)), such as investments in subordinated beneficial interests, investments in subordinated debt instruments, guarantees, written put options, or other derivative transactions of a similar nature. Similarly, some embodiments of the present invention do not include unusual circumstances (as interpreted in view of FIN 46(R)) involving voting rights or lack of voting rights. Each investor may vote its prorated common stock ownership rights; in some embodiments there may be no control group voting arrangements. Under FASB guidelines, investments as discussed in this paragraph may avoid balance sheet consolidation.

[0023] ARB-51, as amended by FAS-94, requires that investments in which a parent company has a controlling financial interest represented by the direct or indirect ownership of a majority voting interest (more than 50%) be consolidated, except in limited circumstances. Neither the sponsor financial institution nor the other investors meet this criteria in certain embodiments. Therefore, this provision would not provide for a consolidation requirement by the sponsor financial institution or the other investors. [0024] FIN-46 (R) interprets ARB-51 and addresses consolidation by business enterprises of variable interest entities that have certain specified characteristics. If a business enterprise has a controlling financial interest in a variable interest entity, the financial statements should be consolidated. FIN-46 (R) is intended to clarify the application of ARB-51 to certain entities in which equity investors do not have the typical characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support. As discussed above, ARB-51 generally requires consolidation when one of the companies in the group directly or indirectly has a controlling financial interest in the other companies and that the usual condition for a controlling financial interest is majority voting interest. However, in some circumstances, application of the majority voting interest criteria may not identify the party with a controlling interest because the control may be achieved through arrangements that do not involve voting interests. As discussed above, in some embodiments, there are no guarantees or other variable interests (except equity ownership). The sponsor financial institution would receive a service fee, expected to be at a fair market value, for providing such services as infrastructure support for general ledger processing, human resources support, and other sales, marketing, and administrative support. In some circumstances, fees paid to a decision maker could be considered a variable interest. If the following four conditions are met, the fees would not be considered a variable interest: (1) the fees represent fair compensation for the services provided, (2) the fees are not subordinate to other operating liabilities, (3) in circumstances other than the first two, the decision maker (and its related parties) does not hold interests that would result in the decision maker absorbing more than a trivial amount of expected losses or returns, and (4) the decision maker can be terminated (i.e., is subject to substantive kick-out rights, as defined). Certain embodiments of the present invention meet all four conditions.

[0025] In embodiments in which the sponsor financial institution participates in the design and origination of the management and investment companies, FIN-46 should also be considered as follows. Under that document, consolidation would require: (1) variable interest, (2) variable interest entity, and (3) primary beneficiary. First, the variable interest criteria is met in certain embodiments because the sponsor financial institution's stock ownership in the management company may be considered a variable interest. Second, there may be a substantial amount of equity at risk. Subordinated financial support is not required. In certain embodiments, owners appear to have normal voting rights, rights to profits, and exposure to losses relative to their voting interests. Finally, in certain embodiments, substantially all activities are not conducted by or on behalf of the sponsor financial institution or any one of the investors in a manner that is disproportionate to their ownership interest. Under these guidelines, the management company may avoid classification as a variable interest entity. [0026] Accordingly, in certain embodiments, none of the investors (including the sponsor financial institution) have a controlling financial interest or a variable interests that would absorb a majority of the management company's expected losses or receive a majority of their expected residual returns. Also, as discussed above, the management company may not be a variable interest entity. Therefore, FIN-46(R) would not provide for a consolidation requirement by the sponsor financial institution or any one of the investors.

[0027] Some embodiment of the present invention avoid having the management company and the investment company classified as investment entities. Accordingly, certain embodiments avoid one or more of the following three features. First, certain embodiments avoid being regulated investment companies, such as those under the Investment Company Act of 1940, SBICs, BDCs, common trust funds, and the like. Second, certain embodiments avoid the inclusion of separate legal entities owned by multiple investors (entities with "pooled funds", as defined), whose primary business activity is investing for current income, capital appreciation, or both. Third, certain embodiments avoid the inclusion of other separate legal entities whose primary business activity is investing for current income, capital appreciation, or both in a separate autonomous business, where a "separate autonomous business" is defined as follows. An entity that obtains benefits (or has the objective of obtaining benefits) that are unavailable to unrelated noninvestor entities is not a "separate autonomous business." An entity that provides significant administrative or support services is not a "separate autonomous business" (a support service fee, as previously discussed, is to be paid to the sponsor financial institution). When an entity or its affiliates direct the integration of operations or the establishment of business relationships, the entity is not considered a "separate autonomous business." Embodiments whose management and investment companies avoid any, or a combination, of these three features may use existing GAAP (e.g., FAS 114, FAS 115, etc.) in accounting for their assets and liabilities, rather than a fair value approach.

[0028] Some embodiments close stock offerings for one or both of the investment company and management company once steps 110 and 120 are complete. In other embodiments, one or both of the investment company and the management company undergo additional rounds of capitalization by selling stock. In such embodiments capitalization at one or both of steps 110 and 120 may provide for convertible and/or anti- dilution provisions regarding the preferred stock to compensate original owners during the successive rounds of funding.

[0029] In some embodiments, the investment company undertakes an initial public offering. Such an offering allows members of the public and other entities to purchase shares in the investment company on the open market. Such an initial public offering may be undertaken once the investment company has been fully capitalized and leveraged. [0030] Embodiments of the present invention may be implemented using hardware, firmware, software, or any combination thereof. Standard computer hardware and/or software programming techniques may be used. Any of the functionality described herein may be performed by computer hardware or software. Such computer hardware or software may convey the results of such calculations to a user by way of a user-readable display, or may convey the results to further hardware or software for further processing. Software may be implemented on a computer readable media, such as, byway of non- limiting example, computer magnetic or optical discs and magnetic tape. [0031] In the preceding specification, various preferred embodiments have been described with reference to the accompanying drawings. It will, however, be evident that various modifications and changes may be made thereto, and additional embodiments may be implemented, without departing from the broader scope of the invention as set forth in the claims that follow. The specification and drawings are accordingly to be regarded in an illustrative rather than restrictive sense.

Claims

We Claim:

1. A method of investing capital by a sponsor financial institution, the method comprising: establishing, by the sponsor financial institution, a management company; purchasing, by the sponsor financial institution, shares in the management company; selling, for a first price, and to a first plurality of financial institutions, shares in the management company, wherein each of the first financial institution and the first plurality of financial institutions owns less than 20% of the management company, whereby the sponsor financial institution and the first plurality of financial institutions own an entirety of the management company, and whereby the sponsor financial institution and the first plurality of financial institutions are not required to consolidate the management company in their financial statements; establishing an investment corporation; purchasing, for a second price and by the management company, shares in the investment corporation; selling to a second plurality of financial institutions shares in the investment corporation, whereby the management company owns less than 20% of the investment corporation, whereby each of the second plurality of financial institutions owns less than 20% of the investment company, whereby the second plurality of financial institutions are not required to account for dividends on the shares in the investment company using an equity accounting method; purchasing, by the investment company, a first plurality of mortgage backed securities; borrowing first capital, by the investment company, using the first plurality of mortgage backed securities as collateral; using the first capital, by the investment company, to purchase a second plurality of mortgage backed securities; borrowing second capital, by the investment company, using the second plurality of mortgage backed securities as collateral; and paying dividends, by the investment company, on the shares in the investment company; wherein the investment company accounts for the first plurality of mortgage backed securities and the second plurality of mortgage backed securities as assets.

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2. The method of claim 1 , wherein the first plurality of financial institutions comprise a plurality of credit unions.

3. The method of claim 1 , wherein the first plurality of financial institutions comprise a plurality of banks.

4. The method of claim 1 , wherein the first plurality of financial institutions comprise a plurality of savings institutions.

5. The method of claim 1, wherein the second price is substantially equal to the first price.

6. The method of claim 1 , wherein the second plurality of financial institutions comprise a plurality of credit unions .

7. The method of claim 1 , wherein the second plurality of financial institutions comprise a plurality of banks.

8. The method of claim 1 , wherein the second plurality of financial institutions comprise a plurality of savings institutions.

9. The method of claim 1 , wherein the first plurality of financial institutions consist of a plurality of credit unions and wherein the second plurality of financial institutions consist of a plurality of credit unions.

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