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Edited Transcript of BANX earnings conference call or presentation 8-Aug-19 9:00pm GMT

Q2 2019 StoneCastle Financial Corp Earnings Call

New York Aug 11, 2019 (Thomson StreetEvents) -- Edited Transcript of StoneCastle Financial Corp earnings conference call or presentation Thursday, August 8, 2019 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Joshua Stuart Siegel

StoneCastle Financial Corp. - Chairman & CEO

* Patrick Joseph Farrell

StoneCastle Financial Corp. - CFO

* Rachel Schatten

StoneCastle Partners, LLC - General Counsel and Chief Compliance Officer

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Conference Call Participants

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* Brian J. Mckenna

JMP Securities LLC, Research Division - Associate

* Christopher Thomas O'Connell

Keefe, Bruyette, & Woods, Inc., Research Division - Assistant Analyst

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Presentation

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Operator [1]

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Greetings. Welcome to StoneCastle Financial Second Quarter Financial Release Conference Call. (Operator Instructions) Please note, this conference is being recorded. I will now turn the conference over to your host, Rachel Schatten, General Counsel for StoneCastle Financial. Thank you. You may begin.

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Rachel Schatten, StoneCastle Partners, LLC - General Counsel and Chief Compliance Officer [2]

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Good afternoon. Before we begin this conference call, I'd like to remind everyone that certain statements made during the call may be considered forward-looking statements based on current management expectations that involve substantial risks and uncertainties. Actual results may differ materially from the results stated in or implied by these forward-looking statements. This would depend on numerous factors, such as changes in securities or financial markets or general economic conditions; the volume of sales and purchases of shares of common stock; the continuation of investment advisory, administrative and service contracts; and other risks discussed from time to time in the company's filings with the SEC, including annual and semiannual reports of the company.

StoneCastle Financial has based the forward-looking statements included in this presentation on information available to us as of June 30, 2019. The company undertakes no duty to update any forward-looking statement made herein. All forward-looking statements speak only as of today, August 8, 2019.

Now I will turn the call over to StoneCastle Financial's Chairman and Chief Executive Officer, Josh Siegel.

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Joshua Stuart Siegel, StoneCastle Financial Corp. - Chairman & CEO [3]

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Thank you, Rachel. Good afternoon, and welcome to StoneCastle Financial's Second Quarter 2019 Investor Call. In addition to Rachel, joining me today is George Shilowitz, President; and Pat Farrell, our Chief Financial Officer.

I would like to start the call today with an updated StoneCastle Financial's quarterly results and portfolio review. Then, I will turn the call over to Pat, who will provide you with greater detail on our financial results before I open up the call for questions.

Net investment income for the quarter was $2.5 million or $0.38 per share. Total assets were approximately $168.2 million and the value of the investment portfolio was approximately $165.1 million. The net asset value at the end of the quarter was $21.80 per share, up $0.17 from the prior quarter. We believe no meaningful credit issues currently exist within the portfolio, and the majority of the underlying banks continue to be scored investment-grade by Kroll Bond Rating Agency.

Now let me turn to the portfolio review. As expected, this was another quiet quarter within the community banking industry. That said, StoneCastle made an investment in the TARP issuer, Fidelity Federal Bancorp Series A and B cumulative perpetual preferred shares, both of which are 9% coupons. According to S&P Global Market Intelligence, debt offerings by all U.S. banks and thrifts below $10 billion in assets were reported to be only $176 million in Q2, with a weighted average coupon of 5.27%. During the quarter, we had $12.9 million of securities redeemed with the majority of the proceeds coming from Reliance Bancshares preferred stock. However, we are in discussions with an issuer for a transaction of approximately $10 million that we believe will have an estimated yield above 10%. Even with the redemption of Reliance, StoneCastle's estimated annualized portfolio yield was approximately 9.16%. The quarter end schedule of investments can be found on the company's SEC filings and on the company's website.

Now let me make some comments on the market. As our shareholders know, StoneCastle's portfolio was focused on making bank regulatory capital investments, using a number of different investment structures, including, but not limited to, bank stock loans, senior debt, sub debt, preferred stock and common equity. As fiduciaries, we are tasked with looking for investments that align with our long-term strategy. As I mentioned earlier, there is relatively little sub debt issuance in the current market and recently closed transactions, in our opinion, are not at rates commensurate with the risk assumed. Therefore, in current market conditions, where rates remain low and in a market that feels closer to the top of the credit cycle, we believe there are more advantageous risk-reward transactions to be made and patience is warranted.

We are looking at regulatory capital relief transactions, which are typically issued by larger banks. These types of transactions provide credit enhancement against commercial loan portfolios, which result in banks lowering the risk-weighted assets on their balance sheet. To put this in better context, large banks that are subject to the restrictions of Basel III have 2 primary ways to improve their capital ratios, they can raise common equity or lower their risk-weighted assets. At this time, and particularly with the current volatility in the markets, bank equity valuations remain low and companies are less interested in issuing traditional common equity. However, while not novel, a useful tool for banks to lower risk-weighted assets are regulatory capital relief transactions. These transactions typically pay attractive rates of return to purchasers. Yet the financial institutions cost is still cheaper than issuing traditional common equity at current market valuations. It is important to note that these are not off-the-shelf transactions. They take time and quite a lot of work to source and negotiate. We are currently evaluating a number of these types of transaction with the potential to invest in the coming quarters.

Now let me make a few comments specific to our stock. In the current market environment, where the 10-year treasury has declined by over 90 basis points since the beginning of the year, StoneCastle's stock continues to offer relative value as evidenced by the stability in our stock price and the current approximate 7% yield. Given the current market volatility and uncertain macro environment, I want to also point out that an investment in StoneCastle Financial is primarily a pure-play on the domestic economy. Currently, with approximately 60% of our dollar-weighted underlying bank investments in the heartland of the country, BANX offers a strong geographic diversification across 33 states.

Finally, I want to emphasize StoneCastle's discipline on credit quality, with the majority of our underlying banks scored investment-grade or better. This will become a more important characteristic as we continue along the credit cycle.

Now I want to turn the call over to Pat to discuss the financial results and provide details on the underlying value of the company.

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Patrick Joseph Farrell, StoneCastle Financial Corp. - CFO [4]

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Thank you, Josh. As I do each quarter, I will present the financial results by going through the components of the company's quarterly results in detail. The net asset value at June 30 was $21.80, up $0.17 from the prior quarter. NAV is comprised of 4 components: net investment income; realized capital gains and losses; the change in value of the portfolio's investments; and lastly, distributions paid during the period.

Let's look at these components. Gross income for the quarter was $4.05 million or $0.62 per share. Net operating expenses for the quarter were $1.58 million or $0.24 per share, resulting in a net investment income for the quarter of $2.47 million or $0.38 per share, unchanged from the first quarter.

The second component affecting the change in NAV for the quarter is realized capital gains and losses. The net realized capital loss for the quarter was just under $110,000 or less than $0.02 per share. This was due to the call of an asset purchased at a premium.

Third component, changes in unrealized appreciation or depreciation of the portfolio, relates to how the value of the entire investment portfolio has changed from the previous quarter end to the current quarter end. For the second quarter, the unrealized appreciation of the portfolio increased by approximately $1.2 million or $0.19 per share. The majority of our portfolio holdings increased in value this quarter, with the largest increases coming from our bank credit securitizations and equity holdings. At quarter end, the closing stock price of StoneCastle traded at a slight premium to the actual market value of the net assets of the company.

The fourth component affecting the change in net asset value is distributions. The cash distribution for the quarter was $0.38 per share. The distribution was paid on June 26 to shareholders of record on June 20.

In summary, we began the quarter with a net asset value of $21.63 per share. During the quarter, we generated net income of $2.47 million, a net realized capital loss of approximately $110,000 and the unrealized value of the portfolio investments increased by $1.2 million. The sum of these components, offset by a distribution of $0.38 per share, resulted in a net asset value of $21.80 per share at June 30, up $0.17 from the prior quarter.

As I do every quarter, it is worth noting that the vast majority of the portfolio continues to be independently marked from broker-dealer quotes. For the quarter, approximately 94% of the portfolio prices or marks reflect a minimum of 2 quotations or actual closing exchange prices. These quotations represent an independent third-party assessment of the current value of the portfolio. This differentiates StoneCastle from certain publicly traded closed-end funds and BDCs that self mark their portfolios.

At quarter end, the company had total assets of $168.2 million, consisting of total investments of $165.1 million, cash of approximately $160,000, interest and dividends receivable of $2.2 million and other assets of approximately $650,000 representing prepaid assets. Our dividend yield at the end of the quarter was approximately 7%, which is nearly 3x higher than that of the average community bank.

Now let me update you on the balance of our current credit facility. At June 30, the company had $24 million drawn from the facility. Based on regulated investment company rules, we may only borrow up to 33.3% of our total assets.

Now I want to turn the call back over to Josh.

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Joshua Stuart Siegel, StoneCastle Financial Corp. - Chairman & CEO [5]

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Thank you, Pat. Now operator, we would like to open up the call for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question is from Devin Ryan with JMP Securities.

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Brian J. Mckenna, JMP Securities LLC, Research Division - Associate [2]

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This is Brian Mckenna for Devin. So first one for me. Net investment income has come in right on top of the quarterly dividend in the past several quarters. I know it's a pretty benign backdrop in terms of sourcing deals right now, and you've been pretty creative on finding additional yield. But how are you thinking about dividend coverage today as you factor in some of the puts and takes of the model? And then on the same topic, just as it relates to the call proceeds. Do you have any visibility into the book for the next couple of quarters?

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Joshua Stuart Siegel, StoneCastle Financial Corp. - Chairman & CEO [3]

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Sure. Both good questions. Yes, we try to be creative. I think we're going to be able to remain creative. While I can't obviously give forward-looking, as we've said just a few moments ago in our comments, we're actively working on a number of positions. In fact, this week, we traded -- it hasn't settled yet, right? Trades can always fail. But we did trade a $10 million block in -- north of 10% yield. So obviously, you guys can run your own math on that. We're looking for more, and we'll see what happens over the next month or 2.

But I do think we'll be able to put some very interesting assets that fit our risk-return profile and actually are quite accretive to the portfolio on the books, unless something strange happens. I think the traditional sub debt remains very slow. I mean, obviously, the markets are in complete disarray right now and not sure between a Fed decrease, credit spreads all over the place, hard to know where to go. But we're paid to be fiduciaries to look out for our investors' best interests, and if that means having more dry powder in case of a correction occurs or finding interesting investments, that's what where we're here to do.

And to the second part of your question about dividend coverage. The Board reviews every single quarter where we are and the forward look of our current portfolio. And based upon that, we're going to make our dividend policy. Right now, we're covering. We obviously don't always know every call that comes. Some of these, like the First Reliance, we do because we get the notification from the issuer. But based upon where our portfolio is today, including the net of what went out, at the moment, we're fine covering. But I think there's good odds -- I can't promise, but good odds that the coverage will continue. And in fact, just to give you some more color. I think we only have 2 TARP issuers left in the portfolio, so there's not much more of that, that comes out. All the new way stuff is longer. Some of the things we're looking at now are probably noncall 3, 4, 5. They're not sub debt, so they're a little different. But anything we're putting on, we're trying to get as long a lock out as we can.

And I do -- I'm sure I'm not unique here because obviously, I talk to a lot of my peers running other vehicles in the industry and people who I look up to in terms of their view of the economy and the markets is, we are definitely really rounding the top of the credit cycle here. So putting a whole bunch of things on right now, as we said last quarter, it's just not what we want to do when we are very comfortable being patient. It may not put the most management fees in our pocket, but as people have learned in 6 years, that's not what we're about. So we're going to find the best things. And if we can't find them, we'll sit tight.

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Brian J. Mckenna, JMP Securities LLC, Research Division - Associate [4]

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Got it. Helpful. And then just given the fluid macro backdrop in the inverted yield curve, how is your portfolio positioned for this? And then can you remind us whether you think opportunities to provide capital would increase into or during an economic downturn? Or how that would affect your business more broadly?

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Joshua Stuart Siegel, StoneCastle Financial Corp. - Chairman & CEO [5]

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Sure. Well, the smaller banks have always enjoyed, en masse, better net interest margins than the larger banks because the customers of community banks don't mind paying a little bit more for the same loan than customers of the larger banks, and that's not an opinion, that's a fact. Again, I always love quoting John Adams, "Facts are stubborn things." FDIC gives all the data for every bank every quarter. So we can see that these smaller banks, while they have sort of a higher expense ratio because of their size, they can weather a little compression in NIM.

But they also have more pricing power in their local markets. Local customers are not walking away for 25 basis points. So they have more flex, and we've seen that more through StoneCastle's deposit business at StoneCastle Partners. Obviously, we have deposits at over 850 institutions in all 50 states. So we see what's happening at a very granular basis. And I have to say, banks are a little perplexed with this Fed decrease of how to handle it. Some banks are raising rates to try to do a land grab on deposits. Some banks are dropping a lot more than the 25 bps. So it's very interesting to see that they're all testing to see how customers will react. But to your question and to keep it reasonably tight, I don't foresee that the current economic policy or foreign trade issues, the yuan versus the dollar, it's just -- as always, and that "always" meaning decade after decade after decade, has very little direct effect on community banks. Right? The hardware store, the borrower, the local manufacturer, it's a domestic play.

And while, yes, if the dollar strengthens, foreign goods become more expensive, and -- but that's sort of the tail, it's not the dog. So historically, small banks are reasonably recession-resistant. On research I did long before I started StoneCastle, there's been less than 0.1% correlation to community bank failure rates to the S&P 500 -- it used to be the Lehman BBB Bond Index, long gone, it was an old study, in periods of U.S. recession, just reasonably uncorrelated. And I think we've seen that in our stock and the sort of beta of our stock, right, being so low. It's just -- it isn't really correlated on the up or down, it just sort of sits.

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Brian J. Mckenna, JMP Securities LLC, Research Division - Associate [6]

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Yes. Got it. And then last one for me, for Pat. I know it's a bit of a moving target, but given the interest rate backdrop, could you remind us, just on some of the moving pieces on your credit facility and how we should be thinking about interest expense going forward?

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Patrick Joseph Farrell, StoneCastle Financial Corp. - CFO [7]

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Sure. So in Q2, rates dipped down just a little bit. I mean, I've mentioned before that when we -- we borrow when we need to. So we tend to have multiple tranches, if you will, outstanding at any time based on when we've borrowed in order to settle a trade. That gives us also the flexibility to pay down the loan. Any time we have a call that comes in, we immediately paid that down right away to lower our interest expense, which is why you'll see and have seen in this quarter, our interest expense went down pretty dramatically for the quarter. So looking forward, we have that flexibility to draw it as needed when we need it. We have seen in -- since the end of the quarter, rates have come down, obviously. So that's something that we're tracking as well. I think you may recall that we are based on -- about 1.5 years ago, we renegotiated the loan, and we saved about 50 bps on that. We used to be at 1-month LIBOR plus 2.85%, we're at 1-month LIBOR plus 2.35% now, which is a -- which was a nice pickup back then and realizing that now as well. Anything else I can add to that for you?

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Brian J. Mckenna, JMP Securities LLC, Research Division - Associate [8]

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No, I think that's it.

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Operator [9]

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(Operator Instructions) Our next question is from Chris O'Connell with KBW.

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Christopher Thomas O'Connell, Keefe, Bruyette, & Woods, Inc., Research Division - Assistant Analyst [10]

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So just wanted to kind of touch upon the previous question and just get a little bit more detail on maybe how the net investment income kind of tying into your comments on the credit facility. And just assuming maybe a static portfolio, nothing coming off and no future yields coming on, just how the portfolio would react to each individual kind of 25 basis point cut from the Fed?

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Joshua Stuart Siegel, StoneCastle Financial Corp. - Chairman & CEO [11]

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So let's sort of break the 2 down. So as we reported in our script, we -- even with the call that just occurred, we're at about a 9.16% yield, right, on the portfolio. Now if we -- just to sort of, let's go to the left and to the right, I'll explain. If you go to left, let's just say, we still have another redemption. And now we're unlevered, right? We're basically just using capital. If we're still in the high 8s or low 9s, and of course, the interest expense goes away if we're not using the credit line at all, I just -- you can run the math, we are kind of where we are. I mean, okay, maybe it's plus or minus $0.01 or $0.02, but it just doesn't move very much. If this trade settles as expected, now we've picked up something that's north of 10%, I can't quote it until it finally settles, but north of 10% yield on another $10 million block, you can run them at math as well.

And if we're borrowing at 1-month LIBOR plus 2.35% and LIBOR was up quite a bit, you can -- again, I have to be vague as I don't give forward-looking statements, but obviously, you're an experienced analyst, you'll run the numbers. Borrowing from our credit facility at that kind of low rate and putting it out north of 10%, even if it was 10% flat for an assumption for modeling, for argument's sake, it's quite accretive. So I think where we are and where we look forward, we're very comfortable where we are in terms of generating consistent income. And I think that for things that are going on, despite the backdrop, that we're going to be able to improve upon that in the coming quarters unless something doesn't go as we are currently seeing. So yes, I think we're in a good spot. And I think that there'll be -- given the dislocation, our job is to look at the banking space and find the mispriced assets. I mean, that was how we create StoneCastle Financial in the first place was finding really high-quality assets, which we said that 6 years ago, I think people do believe us now, very high-quality assets that we're overpaying.

Due to lower issuance and a bunch of factors, it's slowed down on that, but we've now uncovered some other interesting trades, that are still financial but take advantage of the fact that the markets for equity have shifted relative to fixed income, and we're going to try to take advantage of those. And we're still looking at a few things that are in the bank services space as well. We haven't traded anything on that yet, but we're working on a couple of deals. So I think the next quarter or 2, we think we're going to try to do a pretty good job of improving upon where we are, right? It's -- given where we are in the cycle, it's focusing on capital preservation, but of course, still finding ways to improve our net interest margin and our net interest income.

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Patrick Joseph Farrell, StoneCastle Financial Corp. - CFO [12]

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Yes, I'll just add to that, that -- to state the obvious, that lower rates goes right to the bottom line for StoneCastle Financial Corp. And if you go back to Q4 rates that had moved up pretty substantially there, up to close to 5% as our average rate for the quarter, so if we were closer to 5% then and this quarter ended at about a 4.80%, mid-4.80s, and since then, rates have come down as well. So it's certainly helpful for us in that sense. And then as we put more money to work also like, EE, if you will, to our bottom line, very helpful.

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Joshua Stuart Siegel, StoneCastle Financial Corp. - Chairman & CEO [13]

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The other thing, Chris, that are just fascinating -- it's fascinating in both ways. When credit spreads widen and the market softens like what happened at the end of last year, right, our net asset values just didn't move very much, right? One, we think they should have, right? Because credit spreads widened out, but they didn't. Well, now look at the other side, right? We have a lot of fixed rate paying assets. The 10 years in 90 basis points, and let's just even say, because it's hard to calculate exactly, let's say it's the 5- or 6-year duration of our portfolio. So shouldn't we be like 25 -- the whole value of the portfolio have gone up 25%, mathematically, bond math, right? University of Chicago would say yes. But no, it's gone up like a couple of percent, right? It just has this strange dynamic of it just sort of sits.

Will it always do that? Who knows? But it's done that for 6 years. In fact, 6 years of StoneCastle Financial. But I've been watching the space my days at Salomon, the 1990s, it's been doing this for decades. So we've basically -- if you think about where we are in the credit cycle, the credit quality we're sitting on and the fact that we're -- not that we can ever be very levered because we're going to stick to, as Pat just said, the 33.3% of assets. But we're now, at the moment, delevered, which means we're even less risky than we were. So we have assets that haven't really reflected the appreciation of the rate of return relative to the 10-year, right? We have a diversified portfolio, still on average underlying credit quality BBB and we're delevered. So let's get a $25 target on it. I mean, I'm having fun, right? It's just fascinating to watch how the market looks at these types of assets or maybe the case is they're not looking at it. And that's why they just -- they focused on the troubled ones and not us.

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Christopher Thomas O'Connell, Keefe, Bruyette, & Woods, Inc., Research Division - Assistant Analyst [14]

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Got it Appreciate the color. And then -- I hopped in the call a bit late. But it sounds like you guys were looking at some regulatory capital relief transactions. And you had just mentioned some of the bank service transactions that you're trying to develop, but are maybe a little bit longer term. Can you just walk us through some of the details on how the regulatory capital relief transaction might work? And any read into a time line on the kind of bank service transactions and when you might see that come to fruition?

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Joshua Stuart Siegel, StoneCastle Financial Corp. - Chairman & CEO [15]

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Sure. I'll do it in reverse order. On the bank services, those are -- sporadically, we've seen 2 or 3. We passed on one of them, it was just too small. We're looking at 2 others now. They may or may not happen. They're more sporadic. So I really -- to give any timing of when would just be crystal ball, so I can't do that. On the regulatory capital relief, I mean, there are various types -- there isn't a set of details, each deal is a little different. But regulatory capital relief transactions have been around for decades. I mean, they were used in the mortgage space back into the late '80s, early '90s. So there's nothing new about them. They just don't always make sense depending on where equities and credit spreads are. But equities are off. And so there are larger banks that have two choices, they can either raise CET1, Common Equity Tier 1, right, which actually raises equity and, of course, the ratio relative to the risk-weighted assets.

Then you have the other option, which is for these larger banks to say, I don't want to get rid of my portfolio of assets, right? I mean, I've worked hard as a bank to build the relationships with these borrowers. So I don't want to just tell my borrowers to leave because I'm tight on my regulatory capital, right? I want to maintain well capitalized status, okay? So I don't want to tell them leave. I don't want to sell the loans. So I want to keep the relationships but I need to improve the quality of what I'm holding. And so the general approach of these is they've been around for a long time. It allows a bank to be able to increase the credit quality of what it holds by effectively selling off a first loss piece against a very, very diversified, usually hundreds of underlying credits in very small positions. And so -- and it could be in any variety of asset classes, most usually commercial loans. And so that's the general flavor. But obviously, it's an area that it's -- you can't just buy these off the shelf. They're not just sitting there on Bloomberg to buy. They're very hard to come by. And we've been working on this for a while, as we do in our normal skunkworks here. And so we entered into a trade, which hopefully will settle in the next week or 2. It may not, you never know. Nothing's ever done till it's done. But we're looking at more of these as well. So that's about as much as I can give and probably as much as I want to give because I don't want to teach our competition.

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Operator [16]

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We have reached the end of our question-and-answer session. I would like to turn the conference back over to management for closing remarks.

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Joshua Stuart Siegel, StoneCastle Financial Corp. - Chairman & CEO [17]

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Thank you, operator. Well, as always, thank you for listening. We appreciate your support and the time you take to understand our company. Enjoy the rest of your summer, and we'll see you this fall.

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Operator [18]

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Thank you. This concludes today's conference. You may disconnect your lines at this time, and thank you for your participation.

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Joshua Stuart Siegel, StoneCastle Financial Corp. - Chairman & CEO [19]

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Thank you, operator.