Banks in ‘Downward Spiral’ Buying Capital in CDOs

Wednesday, June 9, 2010
By Paul Martin

By Yalman Onaran and Jody Shenn

June 8 (Bloomberg) — U.S. banks are fighting to preserve the use of securities that help them appear better capitalized, even as their investments in each others’ notes perpetuate what one regulator calls a “downward spiral” of losses.

The cross-ownership, largely unnoticed by bank supervisors who generally discourage the practice, was made possible by a Wall Street innovation like the ones that allowed subprime mortgages to flourish. Small lenders, such as Riverside National Bank of Florida, were able to sell trust-preferred securities, known as TruPS, because investment bankers packaged them with those issued by dozens of other financial institutions.

Riverside, which started in a trailer in 1982, bought collateralized debt obligations made up of TruPS as it grew to 65 branches and $4.8 billion assets. When real estate soured and lenders racked up loan losses, Riverside and about 400 of its peers suspended interest payments on their TruPS, causing the CDOs to default or lose value and inflicting more harm on an industry suffering from the worst economy since the 1930s.

“The industry was self-financing, using loopholes in rules,” said Joseph Mason, a professor of finance at Louisiana State University in Baton Rouge. “Regulators weren’t keeping track of ownership of the capital, which became more difficult to do with the use of CDOs. The losses fed on each other.”

Collins Amendment

Riverside, based in Fort Pierce, Florida, was one of almost 1,400 U.S. lenders that had issued $149 billion of trust preferreds by the end of 2008, according to the Federal Reserve Bank of Philadelphia. About $45 billion of CDOs filled with such TruPS were created by the time the market for securitized debt shut down that year, according to PF2 Securities Evaluations, a New York-based company that helps banks and funds evaluate CDOs.

Congress may end the use of TruPS as capital, forcing banks that issued them to replenish their coffers. Banks are lobbying to remove a provision barring their use that was introduced by Maine Republican Susan Collins and included in the financial reform bill passed by the Senate last month. The Senate version is being reconciled with one passed by the House of Representatives in December that doesn’t include a ban.

“We’re still working to try to minimize the damage the amendment would do to bank-holding company capital,” said Mark Tenhundfeld, executive vice president of the American Bankers Association, which predicts the rule could force banks to raise as much as $130 billion of new capital or curtail lending.

‘Modifications’ Possible

Collins said today lawmakers may have to grandfather existing TruPS or implement the ban over time. “Clearly we need some sort of phase-in,” she told reporters.

Lobbyists for the Independent Community Bankers of America, a Washington-based group representing about 5,000 smaller lenders, have met with key lawmakers in recent weeks to discuss the capital issue.

If the Collins provision survives, it will come too late to undo the damage caused to Riverside, which was shut by the Federal Deposit Insurance Corp. on April 16. The bank has sued the firms that sold the TruPS CDOs for not disclosing that they were marketed to other lenders and the rating firms for overstating the creditworthiness of the securities.

TruPS are securities issued after a bank-holding company sells debt to an off-balance-sheet trust, which then sells the notes. They’re considered a type of capital for regulatory purposes because they rank between common stock and senior debt in a bankruptcy. The notes allow a bank to defer making interest payments for up to five consecutive years. Unlike other types of preferred stock, they have fixed maturities, and missed dividends must be paid later. For tax purposes, they count as debt, and the interest paid out can be deducted like other interest expenses.

Pooled Assets

CDOs that bundled TruPS are similar to other complex products designed by Wall Street banks that pooled assets such as mortgage bonds and loans used in leveraged buyouts into new securities, with varying risks and ratings. CDOs were among the largest sources of the $1.8 trillion of losses suffered by the world’s biggest financial companies that required governments worldwide to bail out banks with taxpayer funds.

While TruPS have been around since the 1980s, they gained wider acceptance when the Federal Reserve, which regulates bank- holding companies, allowed them to be treated as Tier 1 capital in 1996.

FDIC Objects

The Office of the Comptroller of the Currency, which oversees bank subsidiaries of holding companies, wasn’t happy with the rule change and never implemented it, according to three officials with knowledge of the discussions. As a result, it was Riverside’s parent company, Riverside Banking Co., which issued the trust preferreds.

The FDIC has also objected to TruPS as being too weak for capital purposes, according to George French, the agency’s deputy director for policy in the division of supervision and consumer protection. The agency’s chairman, Sheila Bair, expressed support for the Collins amendment in a letter she sent the senator on May 7, the day it was introduced.

The agency’s view was confirmed during the financial crisis, French said. Banks couldn’t use their TruPS as capital because deferring the dividends would have been seen as weakness, which could have led to bank runs. When payments were deferred, they caused losses for the TruPS held by other banks.

‘Downward Spiral’

“It contributes to a downward spiral,” French said.

Proposals by the Basel Committee on Banking Supervision, which brings together regulators and central bankers of 27 countries, would also eliminate TruPS for use as capital.

When TruPS were first introduced, only the largest U.S. banks, such as Citigroup Inc. and Bank of America Corp., could issue them. Smaller banks couldn’t sell in sizes large enough to attract investors, and fixed legal and other costs ate into the value of smaller deals for issuers.

A team at Citigroup led by Josh Siegel helped change that by coming up with the idea of pooling TruPS into CDOs and creating the first deal in 2000, convincing rating firms and investors that a diverse pool of banks across the country meant a slice of the debt could be rated AAA. First Horizon National Corp., based in Memphis, Tennessee, and KBW Inc. in New York, two investment banks that had better relationships with community lenders, followed jointly a few months later.

Market Explodes

The introduction of CDOs helped the market explode. Almost 250 of the 459 banks whose shares were listed on major exchanges in 2002 had sold trust-preferred securities, up from about 100 in 1999, according to SNL Financial, a Charlottesville, Virginia-based financial information and research provider.

It also wreaked havoc on the banking sector. The pileup of TruPS on banks’ balance sheets went unnoticed by regulators since they were grouped with other investment-grade debt, according to three banking supervisors who asked not to be identified. Only last June were banks required to disclose their holdings of TruPS CDO in regulatory filings. They still don’t have to report purchases of non-pooled TruPS.

“There wasn’t enough oversight of the systemic risks that the banks’ ownership of these securities could create,” said Mark Williams, a former Fed examiner who teaches finance at Boston University.

Enabling smaller banks to sell TruPS provided them with funds they used to expand into construction lending, commercial mortgages and home-equity debt, fueling a real estate bubble that burst in 2007.

‘Enticed’ by Yields

“It was an extremely cheap way for the smaller banks to raise capital,” said Jeffrey Caughron, an associate partner in Oklahoma City at Baker Group Ltd., which advises community banks investing $20 billion of assets. “The securitization process and the demand created by securitization, created an environment where trust-preferred issuance became very cheap.”

Banks also were “enticed” by the CDOs’ higher yields, Caughron said. One investment-grade TruPS CDO slice sold in December 2006 offered yields that floated 2.70 percentage points above the three-month London interbank offered rate, a borrowing benchmark, Bloomberg data show.

TruPS CDOs helped banks get around restrictions on owning equity stakes in each other. Regulations force banks to deduct from their capital the full amount of any equity holdings in other banks. Trust preferreds, since they are considered debt instruments, carry a much smaller capital charge, similar to that associated with corporate debt. The ownership of TruPS CDOs, if rated investment grade, carried even less capital cost, since securitized debt is deemed to be safer.

Conserving Cash

If a bank bought $100 of Citigroup shares, it would have to hold $100 of capital against that asset. The purchase of $100 in Citigroup TruPS would require only $8 of capital. For $100 of AAA rated CDOs that pool bank TruPS, the amount of regulatory capital to be set aside declines to $1.60.

When the credit crisis hit and banks suspended payments on their TruPS to conserve cash, the value of the securities dropped, leading to losses for the holders. Zions Bancorporation, a Salt Lake City-based lender, saw its $2 billion investment in trust preferreds of other financial institutions decline by a third in value, according to regulatory filings.

John L. Skibski, chief financial officer of Monroe, Michigan-based MBT Financial Corp., the parent of Monroe Bank & Trust, bought about $20 million of TruPS CDOs, most of them before 2006. They have been marked down by about half since.

“I did read through the offering statements, and thought I understood all the details on how they worked and felt that because it was the banking industry they would be good,” Skibski said. “In hindsight, in seeing how the industry has gone down, I would not have bought them.”

Negative Outcome

Skibski’s bank, which started in 1858, didn’t invest in other securitized debt or sell TruPS.

Owning CDOs that pooled trust preferreds had another negative outcome. The suspended payments by issuers caused CDOs to be downgraded by rating firms. When the rating dropped below investment grade, as dozens of them did, the banks’ capital charges against the CDOs could multiply by 60 times.

The CDOs made it difficult for banks to negotiate with holders of their TruPS to convert them into common stock, which would have been the best way to use them as capital without being stigmatized for deferring payments. While investors in higher-rated tranches of a CDO may benefit from a conversion, holders of lower-rated slices wouldn’t, preventing an agreement, according to Andrew Silverstein, a partner at Seward & Kissel LLP law firm in New York who has worked on such deals.

‘Hurting Each Other’

More than 13 percent of TruPS within CDOs had defaulted as of April, with payments suspended on an additional 17 percent, according to Fitch Ratings. Riverside’s default on $99 million of TruPS in 10 CDOs was the largest since December, according to a report by the New York-based rating firm. The bank had halted payments in October 2008. The bank bought $211 million of TruPS CDOs, according to its lawsuit.

“When the buyers and the sellers are the same, they start hurting each other,” said Joel Laitman, a New York-based partner at law firm Cohen Milstein Sellers & Toll PLLC who is representing Riverside in its lawsuit.

The case, filed in New York State Supreme Court in November, was brought against the firms that sold CDOs to Riverside, including First Horizon, KBW, Citigroup, JPMorgan Chase & Co., Credit Suisse Group AG and Merrill Lynch & Co. It also named rating firms Moody’s Investors Service, Standard & Poor’s and Fitch. The FDIC was added as a plaintiff on June 3, the same day the case was moved to federal court.

‘Negative Loop’

In a motion to dismiss the case, the investment banks denied that they made any misleading statements and said that Riverside was a sophisticated institutional investor that should have done its homework. A separate motion by the rating firms said Riverside had failed to identify any statement by them that could be considered fraudulent. Both motions are pending.

“Regional and small banks weren’t aware that these CDOs were being marketed to other banks,” said Laitman. “This created a negative loop. Investment banks selling this stuff were the only ones who knew about this.”

Vernon D. Smith, Riverside’s founder and head until retiring in 2009, who has also owned a cattle ranch, citrus groves, radio stations and a weekly newspaper in Florida, didn’t return telephone messages left at his house.

Super Bowl Tickets

TruPS CDOs are also at the heart of a series of lawsuits brought by the liquidation trustee for Northbrook, Illinois- based Sentinel Management Group Inc., a cash-management firm that collapsed in 2007. The trustee sued First Horizon, KBW and Cohen & Co., a Philadelphia-based securities firm affiliated with a family involved in almost half of such CDOs, saying their bankers bribed a Sentinel employee with Super Bowl tickets, strip-club visits and dinners at restaurants such as Tao in New York to get him to buy risky low-ranking slices of the CDOs.

In March, First Horizon said the Securities and Exchange Commission told it the agency might file a lawsuit against the bank over a transaction with Sentinel.

Jack Bradley, a spokesman for First Horizon, Krista Eccleston, a spokeswoman for KBW, and Megan Livewell, a spokeswoman for Cohen, declined to comment. In legal responses in the cases, the three companies denied they engaged in wrongdoing and disputed some facts.

The trustee also says that the banks arranged to buy back some of the older CDOs from Sentinel as they sold it new ones. The arrangement may have helped get deals done because investors in new CDOs often want to know that the junior-most pieces, also called equity, will be sold, said Howard Hill, a former Babson Capital Management LLC money manager who helped start securitization-related departments at four banks.

‘On the Roadshow’

“When you go out on the roadshow, a question that very often comes up from potential bondholders is, ‘Have you sold the equity,’” he said.

Investment bankers may have used relationships developed helping lenders issue TruPS to persuade them to buy related CDOs, said Joshua Rosner, an analyst at Graham Fisher & Co., an independent New York-based research firm, and co-author of a May 2007 report that said a collapse of mortgage-bond CDOs would roil markets.

“When they didn’t find enough natural demand among only institutional investors, they could turn around and sell back to the very banks that had issued into the last one, or would be selling into the next one,” Rosner said. “It created a big Ponzi scheme.”

‘Shocked’ at Disclosures

Too many banks ended up buying the mezzanine tranches of the CDOs, which went bust faster than the highest-rated ones, according to Siegel, who left Citigroup to co-found New York- based StoneCastle Partners LLC, which manages about $3.1 billion, including TruPS CDOs. He said he didn’t realize that was happening as the market grew and was “shocked” at disclosures about what banks had bought.

“Smaller banks should not have been buying any kind of structured paper” except for simple government-guaranteed mortgage securities, Siegel said. “Unfortunately, too much of this paper has landed back at banks, which really wasn’t what should have happened.”

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