CASE STUDY 2: Original Issue Discount - The Ghost of Funding Past
The Situation
Second Regional Bank, $35B in assets, issued $5B in subordinated debt in 2009 (post-financial crisis) at a steep discount: 8.5% coupon (wholesale funding was expensive because of credit concerns).
That debt had a 10-year maturity, so it was set to mature in 2019. By 2019, rates had fallen (Fed was on pause), and 8.5% debt was extremely expensive to refinance. The bank faced a choice: (a) issue new debt at 3.5% (cost drop of 500 bps), locking in savings, or (b) let the debt mature and refinance at lower rates.
This is a classic "Original Issue Discount" (OID) or "ghost of funding past" problem.
The ALM Analysis
Option A: Early Refinancing (2017-2018)
- Issue $5B new debt at 3.5% (market rate)
- Call/redeem the 8.5% debt early (pay a call premium)
- Cost: Call premium of ~$150M + transaction costs $20M = $170M total
- Benefit: Lock in 500 bps savings; reduce annual funding cost by $250M
- Payback: $170M cost / $250M annual benefit = 0.68 years (very attractive)
- ALM recommendation: Refinance early
Option B: Wait for Maturity (2019)- Let $5B of 8.5% debt mature in 2019
- Issue new $5B at market rates in 2019 (probably 2.5-3.5%)
- Benefit: Avoid call premium ($150M)
- Cost: Pay 8.5% for 1-2 more years (annual cost: ~$150M in excess funding cost)
- Net: Worse than early refinancing
Option C: Don't Refinance (Let it Runoff)- Don't refinance the debt when it matures
- Reduce balance sheet by $5B
- Benefit: Reduce wholesale funding dependency
- Cost: Lose $5B in funding; must find deposits or reduce assets
- ALM implication: Would require deposit growth or asset reductions; probably not viable
The Decision
Second Regional's board chose Option A: Refinance early in 2017 at 3.5%, paying a call premium but locking in savings.
Result:
- Paid $170M upfront
- Saved $250M annually
- Payback period: <1 year
- Accretive to net income (savings exceeded costs by Year 2)
The Lesson
When you have old, expensive debt (from high-rate periods), refinancing during low-rate windows creates significant value. The option value is real: don't leave it on the table.
This is a straightforward ALM value-creation opportunity if you execute well.
Case Study 2: The Mechanics of Debt Refinancing
The Call Premium
When you issue debt, it often includes a call provision (issuer can redeem it early). If you call debt, you pay a premium to the bondholder.
Example:
- Original debt: $5B issued at 8.5%, no call for 5 years (non-callable)
- Year 5: Becomes callable at par + 2% call premium = $5.1B
- Year 6: Call premium declines to 1.5% = $5.075B
- Year 10: Call premium declines to 0% (maturity)
Second Regional called the debt in Year 8, when call premium was about $150M.
The Refinancing Analysis
``
Old debt: $5B @ 8.5% = $425M annual interest
New debt: $5B @ 3.5% = $175M annual interest
Annual savings: $250M
Refinancing costs:
- Call premium: $150M
- Transaction costs: $20M
- Total upfront cost: $170M
Payback: $170M / $250M annual savings = 0.68 years
``
This is a slam-dunk: Positive NPV, short payback.
The Takeaway
Tracking old debt and refinancing opportunities is a core ALM function. Every 6-12 months, review: What debt is coming due? What debt can be called? Should we refinance? Most refinancing during low-rate periods is accretive.